John Paulson's recent investment in casino stocks piqued my own interest in this sector, and I started looking for value in some of the smaller-cap casino stocks. I believe that with the massive consumer retrenchment last year, 2009, should represent the generational low in casino earnings. Any casino companies that emerged from last year with a clean balance sheet and are still making some profits should be well-poised to gain from an economic recovery, and should be able to withstand even a double dip recession. I found one casino company that met these criteria, the small-cap stock Full House Resorts (FLL).
Full House Resorts owns one casino, Stockman's Casino in Fallon, Nevada. It also manages two other casinos, Harrington Raceway and Casino, in Harrington, Delaware, and FireKeeper's Casino, in Battle Creek, Michigan. As of March 2010, the company has $12 million in cash, and no long-term debt. Stockman's Casino is FLL's smallest casino at 8400 square feet It has 280 slot machines and 4 table games, a keno table, and a fine dining restaurant. Stockman's is the largest of several casinos in the city, commanding approximately 36% of slot revenues in the city. Stockman's was acquired by FLL in 2007 for $28 million, when it had a net operating profit of $2.5 million. In 2009, Stockman's net profit has declined to $2 million annually, although it is gaining market share in the city of Fallon and profits are expected to stabilize.
FLL also has a management contract with Harrington Raceway Inc., the owner of Harrington Raceway and Casino. Harrington's Raceway and Casino occupies 35,000 square feet, with some 2100 slot machines, an entertainment lounge, a 350 seat buffett, and a 50 seat diner. The management contract has been in place since 1996 (and will expire in August 2011), and pursuant to the contract, FLL receives a management fee based on Harrington Casino's annual revenues and operating profit, and the fee is contractually guaranteed to increase at least 5% per year. The management fee from Harrington was $4.9 million in 2009. Harrington faces strong competition from nearby casinos in Delaware, and probable new casinos in Maryland, and revenues are expected to hold steady or decline.
Lastly, FLL also has a seven year contract to manage the FireKeeper's Casino in Michigan, which is owned by the Michigan Tribe. FireKeeper's Casino is the largest casino that FLL runs. At 230,000 square feet, it has 2680 slot machines, 78 table games, 12 poker tables, 5 restaurants, and is expected to attract 2.9 million visitors annually. It is the only casino within 100 miles (although there is a new Indian casino under construction some 70 miles to the north), and has just opened in August 2009.
The management contract expires in August 2016, and FLL gets a 26% cut of net operating profits after all expenses and interest costs have been paid, with the Tribe getting the remaining 74% of profits. The fee must split 50% with RAM, a partner which contributed initial capital to the FireKeeper's Casino, although the split will be adjusted to 70-30 in favor of FLL once RAM has fully recouped its initial investment.
In the months since the opening of FireKeeper's Casino, management fees to FLL have been running at $1 million per month. However, RAM is expected to recoup its investment inside of 1 year, and FLL will then be receiving $1.4 million monthly, for an annual fee of approximately $17 million. FLL has 12 employees, 6 senior management, and 6 support personnel, operating out of a small leased office in Las Vegas, Nevada. Corporate expenses run at about $4-$4.5 million annually. Thus, the net income from FLL is about $19.5 million, minus 35% for taxes, or about $12.5 million in owner's cash flow.
FLL's current market cap is about $57.5 million. If you subtract $12 million in cash, this means that the market is valuing FLL's cash flow at only $45.5 million, or about 3.6 times earnings, an earnings yield of some 27%. How can such a bargain exist?
I believe that several factors have led to this mis-valuation. Firstly, FLL is a micro-cap company in an unpopular sector, with zero analyst coverage. Secondly, the completion of FireKeeper's Casino, the major cash flow contributor to FLL, has been delayed repeatedly, and has finally started operations less than 1 year ago. Therefore, investors may not have had time to re-calibrate their expectations. Thirdly, the casino management business model, while less capital-hungry than outright purchase of casinos, may produce a less consistent cash flow, as management contracts have to be re-negotiated when they expire.
We can however, make some conservative projections. Let's say that 2009 is the lowest point in casino earnings, and earnings are expected to remain at 2009 levels even in a double dip recession. Let's also assume that when Harrington's contract expires in 2011, due to a combination of stronger competition and contract renegotiation, earnings from Harrington's drop from $5 million to $3 million. Assume further that in 2016, when the FireKeeper's contract expires, it is also renegotiated downwards. The management cut in Indian casinos tend to range from 20-30%.
However, in 2016, FLL will no longer need RAM as a capital-contributing partner, and will be able to capture the full management fee instead of just 70%. Furthermore, any new management company will have to rebuild a certain amount of infrastructure, and therefore is expected to compete at a disadvantage to FLL for a renewal. If the cut decreases to 20%, but FLL now captures 100% of the management fee, the cash flow to FLL will actually go dramatically up, rather than down. Even under reasonably pessimistic assumptions, beyond 2011, corporate expenses will be covered by the cash flow from the Stockman's and Harrington casinos, leaving fees from FireKeeper's as pure profit, which is likely to run at $15-$25 million, minus 35% for taxes, for a free cash flow or $10-$16 million.
I believe that the cash flow will bottom out at $10 million, and is likely to rise substantially above that in an economic recovery scenario, possibly as much as $20 million. If we apply a PE of 10 to a lowball cash flow of $10 million, we arrive at a target capitalization of $100 million, plus $12 million in cash, for a total of $112 million, or a $6.22 share price, about double its current price.
What are the potential catalysts for re-valuation of this stock down the road?
Firstly, the CEO has been purchasing stock for his personal account, and the company has been repurchasing stock in the recent past (the company repurchased 1.2 million of shares at $1.21 in 2008, shrinking the share base to 18 million), and stock repurchases are ongoing. All this stock repurchases will further increase the EPS. Secondly, 2011 is expected to be a bumper year for FLL even in a recession. Earnings from Harrington's is going to increase to its peak just before contract expiration due to the 5% mandatory minimum increase, and there will be a reset of the FireKeeper's split from 50-50 to 70-30. Therefore, some eye-popping EPS numbers are likely to be recorded in 2011, which will likely finally register with some investors.
In summary, I believe FLL to be conservatively worth at least $6.22 per share. FLL has a completely clean balance sheet and strong cash flows, and will have positive cash flow even in a double dip recession. In the event of an economic recovery, just a modest increase in casino revenues over 2009 is likely to propel FLL substantially above $6, perhaps even to $10-$12.
Disclosure: Author is long FLL