How To Avoid The Margin Of Safety Trap

| About: Full House (FLL)

Could focusing on "Rule #1 – Don’t lose money" actually be doing us a disservice?

The concept of Margin of Safety is so important to investors that we create checklists around it to ensure its existence before making an investment, “Margin of Safety: Don’t leave cash without it.” Check.

But still, we lose money. Retailers can own “untapped” commercial real estate as with Sears Holdings (NASDAQ:SHLD), Japanese companies can be stuffed with JGBs as with Monish Pabrai’s Japanese basket pick Taisei Oncho, and exhibition companies can be loaded with valuable Titanic artifacts like Mark Sellers’s Premier Exhibitions (NASDAQ:PRXI). Margins of safety appear wide, boxes get checked, and yet we can still lose money during our holding period and even in the long run. Why?

Many of these Margin of Safety picks are not increasing their intrinsic values at an acceptable rate, if at all. They either don’t produce excess cash at a satisfactory rate, or they do not reinvest their excess cash in a way that compounds intrinsic value. Buying these companies is almost entirely a bet on the company being repriced in the short term, rather than on its long-term economic future.

What do we do if a company doesn’t get repriced right away? How do we deal with timing risk?

We avoid it altogether. The surest margin of safety for purchasers of stocks comes from paying below intrinsic value for a business that is likely to increase in value at an acceptable rate to the investor.

“Basically, I don’t want to buy any stock where if they close the New York Stock Exchange tomorrow for five years I won’t be happy owning it.“ – Buffett 2006, University of Florida MBA Speech.

One of Buffett’s major contributions (dating back to The Security I Like Best, 1951) was the idea that the patient and hardworking analyst should be able to find opportunities with economic advantages likely to increase the companies intrinsic value over time, and cheap enough to ensure efficient use of an investor’s hard earned capital. Put another way; be businesslike in your approach.

Full House Resorts (NYSEMKT:FLL) – A businesslike investment.

Full House Resorts was founded in the early 90’s through a partnership between Allen Paulson and Lee Iacocca to develop, manage, and invest in casino properties. FLL is currently run by a group of seasoned casino executives, however Iacocca remains on the board and together with Paulson’s estate, owns 15% of the stock.

Since present management took the helm in 2004, FLL has been in the business of generating cash flows from its high margin/low capital requirement casino consulting business, and then investing excess cash into local casino properties. So far, management has steadily grown the casino management/consulting business, and prudently invested its profits.

The management contracts have produced sufficient cash to buy two casinos, and are an important lever for creating value for shareholders. FLL’s most important management contract (approximately 2/3rds of 2010 revenue) is with FireKeepers Casino in Michigan. This contract expires in 2016, and is unlikely to be renewed on terms as favorable as those that currently exist. Indeed part of the skepticism built into FLL’s price comes from the concerns over its ability to continually earn income from management contracts. However, management has demonstrated its ability to win new management business (e.g., the recent Buffalo Thunder consulting agreement and Hyatt Grand Lodge operating agreement) and has stated this as its intention in several communications.

CEO Andre Hilliou from FLL’s last conference call,

We are trying to replace the management contract by another management contract at the end of the day. I think if we can keep on replacing those management contracts as we go forward you have to give some value besides the discounted cash flow (of each contract) to the company, we will keep on replacing management contracts.

Management has also demonstrated its ability to deploy retained earnings intelligently. They repurchased 5% of their shares outstanding at very attractive prices (~$1.21 per share) during the recent recession, and then waited patiently for casino property opportunities as their balance sheet swelled with cash. Then earlier this year, they completed the $43m acquisition of the Grand Victoria Casino in Indiana at approximately 5x trailing EBITDA ($8.5m). The Grand Victoria (renamed the Rising Star) has a 40,000 square foot casino floor that houses 1,300 slot machines, and is situated on a 300-acre property that includes an 18-hole golf course and 201-room hotel. Currently the Rising Star is earning at a run rate closer to $10-12m per year, lowering the purchase multiple to 4x EBITDA.

Competition is a concern in each of the markets Full House operates in, especially in the Rising Star’s market with the planned development of the $400m Horseshoe Casino Cincinnati. While this project will surely impact the Rising Star’s profitability, its construction has been plagued by delays and Full House has demonstrated its ability to compete effectively in other markets.

In the past three years, FLL has earned a 21% cash flow return on its capital, and has increased book value per share by 15% per year. With the continuation of its earnings from management contracts, combined with the intelligent investment of these profits into additional properties, FLL is rapidly increasing its intrinsic value.

And importantly, FLL is cheap. Full House’s current market cap is $50m, which includes $30m of debt and $11m in cash. Compare this to the $21m FLL earned last year in free cash flow, and you have a 40%+ FCF yield in a growing business that you would be happy to own for 5+ years.







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Another way of looking at FLL’s valuation is that you are getting its two casinos at FLL’s cost ($52m book value vs. FLL’s $50m market cap), and then the ~$15m/year management business for free.

The great fortunes of the last century have been created from owning productive businesses that have the ability to compound their intrinsic values over time. Let’s focus our investment efforts on finding these opportunities rather than searching for the next repricing bet on an overcapitalized yet poorly positioned business.

Disclosure: I am long FLL.