Cheap bank stock: Versailles Financial

Just note that a stock like this is illiquid and to really do your own research.  The price swings and the huge bid-ask means you have to be comfortable not being able to sell your shares whenever you want for a reasonable price.  The only way you'll ever have the confidence to do that is if you do your own research to back up the investment.  That being said, Versailles Financial, a small bank in Ohio, looks like a business that one can get comfortable holding through uncertainty.

In the back of my mind, I'm recalling a circa 2008-2009 CNBC news report on how it was such a great time to be opening up a bank.  The logic still applies.  Interest rate spreads are high.  A new bank doesn't have to work through any bad legacy assets.  Loans written today are comparatively safer than loans written in the credit bubble.  Versailles Financial in many ways possesses these characteristics, trades at a fraction of its capital, and is in the process of conservatively expanding its banking operations.  One can evaluate management's underwriting track record as well.  Their loan book held up well over the past few years with very manageable NPLs and little risk to maintaining strong capital ratios.  In many ways this is better than investing a a greenfield bank, which I don't think is possible for retail investors anyway.

Versailles Financial is a tiny savings and loan bank located in Versailles, Ohio where their high school students win state championships and score high in state testing . Despite converting in January 2010, it still trades at 57% of tangible book value and 52% of book value. It is over capitalized, earns modest profits, trades at a substantial discount to tangible book value, and has a clean loan book. Management and the board own 27% of the company in addition to 8% through an ESOP.  The stock trades very thinly, which is probably a big strike in the eyes of many investors.  Outside of management, there is only $3m worth of stock to be bought at current prices.

The share offering was done at $10/share and 427,504 shares were issued. At the current price of $13/share, the market capitalization is $5,557,552. The tangible book value is $9,602,000 ($22.46/share) and book value is $10,714,206 ($25.06/share). The stock trades at a huge discount to tangible book value despite practically no problematic loans – any bank would wish it had only 1.04% of loans past 30 days due and 0.21% considered nonperforming (Versailles current state). This is what happens when management owns 27% of a small town bank. NPLs/Loans peaked at 1.28% in 2008.  They know exactly to whom they are lending and on what collateral/cash flow. Versailles has a tangible capital ratio of 21.8%, and a tier 1 risk-weighted capital ratio of 37.1%. The strong performance of the loan book indicates that problems should be minimal, but in the case that issues arise, the bank has tons of capital.  The bank has performed extremely well throughout the current recession.

The company is earning a runrate of about $200k for 2011, which means that stock trades at a steep 28x earnings. There might be room for additional profits on the margins now that the company is public and incentivized to increase profitability. The bank's efficiency ratio (non interest expenses/revenue) is just below 60%, they are near the bottom limit of necessary expenses and will need to increase revenue to leverage their costs if profits are to expand.

Management and shareholders are aligned. The CEO made $137k and $133k in 2010 and 2009 respectively. In the conversion offering, he purchased $100k worth of stock. The chairman and several directors purchased even larger sums. The directors take home $14-16k in compensation, which pales in comparison to individual ownership stakes ranging from $192-$390k (purchased for $150-250k). The CEO has been at the bank since 1994. The board is mostly comprised of local businessmen. This is an anachronistic small town bank that is conservative and modest.

With such an owner-oriented board and management, the loan book is not likely to get out of hand. The loan book has never had any subprime loans or new fangled financing vehicles. The loan book is divided 75/20/5 in residential real estate, non-residential real estate (agriculture and business), and assorted consumer. The loan book is showing very little trouble. The bank worked its way through higher NPLs since 2008 to where the ratio of total nonperforming assets to total assets is 0.08%. On June 30 2009 and 2008 NPLs to total loans was 0.76% and 0.87% while nonperforming assets to total assets was 0.65% and 0.71%, respectively. To get down to a tangible capital ratio of 10% from loan write downs, the current level of NPLS of 0.21% would have to grow to 11.3% and write-downs would have to be drastic.

Other than expanding the loan book, the only other plan with the raised capital is to build or acquire a large home office which will allow it to offer more traditional bank products. Versailles currently doesn’t have designated parking at their bank. They don’t offer checking or money market accounts. They don’t have an ATM at their location. This might seem like peanuts, but would offer upside in the form of attracting low cost deposits. Its competition consists of 3 other banks in town: Farm Credit Services of America, US Bank, and Second National Bank (division of Park National Corporation, a roll up of local banks). The larger banks benefit from the law of large number watering down poor underwriting policies (theoretically) but Versailles has well incentivized feet on the ground to do business in Versailles, Ohio. If this costs $1.3m (cash held at the holding company level), the bank has the excess capital to devote to it.  It is a worthwhile investment as management and the board have the local connections to draw in customers. They have yet to acquire any land for a branch, so they don’t seem to eager to pay over the odds. If the $1.3m fizzles up and the bank only breaks even with the branch, there is still $20/share in TBV.

The banks funding sources might be considered the weak link in this bank. It is 55/26/19 split between CDs/savings accounts/FHLB advances. This is a relatively expensive funding source, although net interest margins were at 3.78% in the most recent quarter. The bank has room for improvement in its efficiency ratio, currently at 80%.  As the bank progresses with opening up another office, the potential to attract checking deposits or money market accounts will help diversify funding and decrease its cost. This decreased funding costs should be balanced out by an increase in the efficiency ratio.  This still does not justify trading at 57% of tangible book value.

Just theorizing, but this bank could earn a 3% ROE.  If they have a pay out ratio of 50% of earnings, that would equate a 5% dividend yield at current levels, which would drive shareholder interest.  If earnings are retained and continue to generate a 3% ROE, the return would be 10% annually assuming the bank eventually attracts the attention to be priced at 1x TBV.

To recap – extremely well capitalized bank, incentivized management, well performing loan portfolio, low price. The near term catalyst of a buyback is more likely since the 1 year statutory limit on recently public thrifts has now passed. The worst that could happen would be the bank underperforms and gets acquired when the 3 year statutory limit on a thrift conversions change of control provisions. That is about 1.5 years away as the offering occurred in January 2010. Arguably the easy money has been made since the offering with the stock going from $10 to $13, but the stock still trades at a pretty steep discount that can be reversed through buybacks, a successful new home office, a repricing of bank stocks as a whole, or a buyout by a larger bank.

Talk to Andrew about Versailles Financial

Thoughtful look at the implications of more stringent capital requirements on banks

A few days ago on Economix, I ran into some fascinating arguments about the capital requirements of banks.  This paper, which was mentioned in the post, is thought provoking because it really fleshes out the idea of banks as utilities is not only a good idea, but not a terrible thing from the perspective of bank shareholders.  I could just be putting up a straw man, but I think there is a tacit acceptance of the big bank argument that higher capital requirements are bad for shareholders/America/capitalism.  It seems to fit with the narrative du jour that Obama has no business experience and is destroying the capitalist fabric of America with his boneheaded policies.  While I doubt most people want to read a 60 page paper on the subject of capital requirements, luckily one of the authors happens to be a JPM shareholder, and wrote an open letter that provides a more cursory rundown of the paper's arguments.  It is also in reference to JPM stock, so the arguments can easily be applied to bank stocks in general.

The letter can be found here.  A brief excerpt of the letter that should whet the appetite for some grounded-in-logic argumentation:

A flaw in Mr. Dimon's argument concerns the "market-demanded return on capital" that he claims banks must earn. In a well-functioning financial market, investments in Treasury bills "demand" a lower return than investments in risky mortgages. The required return on capital depends on the risk to which it is exposed. When funding with a mix of debt and equity, the lower the leverage, the lower the riskiness of equity per dollar invested, and therefore the lower the return investors require as compensation for bearing the equity risk. ...Mr. Dimon's letter displays JPM's return on equity (ROE). ROE does not measure shareholder value because it is affected, through the market, by leverage and risk.   Reaching a target ROE can be helped by leverage and risk without benefiting shareholders. Thus, if increased capital requirements lead to lower average ROE, this need not mean lower value, because it reflects the reduced riskiness of equity.

The rub with Admati's argument might be that in order to achieve the necessary capital levels, dilution of current shareholders would have to occur.  Given time to respond to capital requirements though, banks are entirely capable of earning their way to that level in a pretty short time frame.  Especially in the current interest rate environment in the US, the mega banks are making a bunch of money preprovision pretax, so they are replenishing their capital base a reasonable clip.  If the risk premium demanded decreases in response to deleveraged balance sheets, will this prove to be a wash for share prices?

Give Andrew your opinion on capital requirement's effect on shareholders

Hilltop Holdings - holding on to a hill of cash

Gerald Ford was 38th president, but the Gerald Ford that interest me is the Gerald Ford who made a bundle in buying up busted banks.  He has been profitably investing in banks for over 30 years and has become a billionaire as a result.  He has several vehicles through which he has been investing in financial companies in the aftermath of the credit bubble.  Hilltop Holdings is one of them.  While blindly following the money is not the most prudent investment strategy, the price of Hilltop appears to offer some room for error and recent events might give some confidence that the company is profitably executing its strategy.  The company trades at 82% of book value, which is quite a discount for a $468m net cash position, a $50m loan with warrants, and a profitable insurance business compared to a $536m market cap.

Hilltop Holdings (HTH) has two buckets, the first is comprised of an insurance company that sell fire and homeowners insurance on manufactured/low value homes predominantly in Texas and a small amount around in other southern states.  The insurance division was acquired in 2007.  The second is a pile of cash.  The pile of cash was also acquired in 2007 in exchange for all the assets of the trailer parks they owned and managed  (the company refers to them as manufactured home communities, but I think this means trailer parks).  Gerald Ford became involved in 2005 and affected this change in 2007 when he became Chairman.  The stated plan for the pile of cash is to make opportunistic acquisitions, ostensibly in the insurance and banking sector based on Ford's expertise.

I'm not knowledgeable about insurance, but from the look of it, the business, called NLASCO, has been underwriting profitably with the exception of 2008 in recent years.  As a property and casualty insurer though, the business is lumpy. It was acquired for $122m in 2007.  The filings break out the operations of the insurance company as the income statement includes the additional expenses of personnel and consulting for finding uses for the companies cash.  I dont' have any strong opinions about this business.  Hilltop bought the company in 2007 and has been conservative in accounting for losses judged by retroactive adjustments (minimal) to claims and keeping its combined ratio under 100 in most years.  So far the return on the investment hasn't been impressive.  Net Income was $6.6m and $7.1m in 2009 and 2010.  Subtracting the net cash position from the market cap, the market seems to be valuing this business in the $18m range or 2-3x earnings.  There isn't much upside form this though because it is quite small relative to the overall market cap.  A repricing to 8x earnings would only mean the stock price increases 5% so while you are getting a good deal, the upside is minimal.

The second bucket is the cash/investments portfolio.  The company is loaning $50m to SWS, a full service brokerage and bank in Texas, at 8% for 5 years in exchange for warrants to purchase 8,695,652 shares at $5.75 each.  This was in response to a buyout offer the bank received for $6.25/share from Sterne Agee.  While I don't know if it applies to this specific deal, these types of deals are usually done because management doesn't want to lose their jobs so they throw shareholders under the bus.  Hilltop is on the beneficial side though because it is getting a great deal (warrants are already in the money) and getting a seat on the board so that SWS can't do to them what it is potentially doing to its current shareholders.  They stand to make some money on this and it is nice to see the cash being spent on promising deals like this.

Gerald Ford owns/controls 26.6% of Hilltop through Diamond Financial, a partnership that Ford is the sole general partner.  Diamond Financial has a consulting agreement with Hilltop where in exchange for $104,000 a month, DF provides financial and acquisition evaluation.  Gerald Ford has also installed Jeremy Ford as CEO, who is his son.  His background is at his fathers various investment vehicles and some investment banking.  Jeremy Ford's brother-in-law is the General Counsel of Hilltop as well.  Hank Greenberg used to say "All I want in life is an unfair advantage."  Nepotism is one of them.

One of the more recent public investments of the Ford clan is First Acceptance Corporation, a direct competitor of Affirmative insurance, which I've written about previously.  First Acceptance has been a real dud.  It was a cash pile several years about before it acquired FAC and has lost 80% of its value since then.  While Ford is a billionaire, that doesn't make him a legend worth investing alongside.  I don't doubt that Ford the elder with his large stake is looking over his son's shoulder, but the mixed investment record doesn't make me want to follow the Fords into Hilltop.  Ford the elder has been making some interesting private investments in distressed financial companies, so it's difficult to know where his priorities are when it comes to directing opportunities to his various entities.  If that is the case, Ford the junior is the one with more authority to invest Hilltop's cash.  He doesn't have the same record as his dad nor the same ownership stake (unless he is invested through the same vehicle of which Ford the elder is the general partner).

While the downside is pretty limited at this price, I don't see tremendous upside.  Gerald Ford is well positioned to make money buying up distressed banks.  He has already made some moves, but not to the benefit of Hilltop shareholders.  The SWS loan is a step in the right direction, but represents only 10% of the company's cash prior to the investment.  Patience and discipline are admirable, but the unexciting NLASCO acquisition, the failure of the FAC acquisition at a prior cash pile company (Liberté Investors, now FAC) and the uncertainty as to Gerald Ford's priorities means that the patience and discipline might not pay off.  There are plenty of opportunities to invest alongside investors with better track records who have strong balance sheets to take make opportunistic investments à la Berkshire, Leucadia, Brookfield Asset Management, Loews, etc.  Although the discount to book is interesting, one must also recognize a poor comparative track record and uncertain alignment of interests compared to other publicly traded investor bandwagons on to which you can jump.

Give Andrew an opposing opinion on HTH

Odds and Ends on Identifying Opportunities in Banks

I'm late to the party, but banks are beginning to look interesting - maybe because I'm just beginning to look.    Smaller banks have been smacked around for a variety of reasons.  Competition is pretty fierce.  Some have gobs of shitty loans on their balance sheets.  The market did throw the babies out with the bath water, but now some of the better regional or small saving and loan banks have been repriced to a realistic level.  I find the mutual thrift conversions to be the most interesting area because there are many still coming to market that have strong balance sheets and conservative underwriting standards.

Mutual thrift conversions are a unique transaction that Klarman and Greenblatt highlight in Margin of Safety and You Can Be A Stock Market Genius, respectively.  Basically a thrift issues shares to the market and purchasers end up owning the proceeds of the offering as well as the bank itself since nobody owned the bank prior to the offering.  It's a case of 2+2=5 since the bank doesn't have any shares outstanding, but the bank can't sell shares for nothing.

The typical example is when you can purchase the bank for 50% of tangible book value.  A bank worth $10 has a share offering for proceeds of $10.  The stock trades for $10, but it represents $10 in proceeds and $10 of bank.  What is interesting with some of the small (<$30m) offerings is that interest is so low that some offerings have been below 50% of tangible book value.  While I missed the boat on those, there are still some upcoming.  The nice thing is that even if they are up 20-30%, they still trade at a substantial discount to tangible book value despite having enviously low levels of bad loans, so they are still worth looking at.  Every thrift needs to apply to the OTS to convert.  The OTS is going to be disbanded shortly, but you can find all the application letters here so that you can follow the upcoming conversions.  All their prospectuses are available through EDGAR.  Even though the banks don't have 10 years of information filed with the SEC, they have had to report transparent financial data to the FDIC.  This allows someone to go back in time and see how their loans have performed and what kind of growth the bank has seen.

What first got me interested was this write up of a mutual thrift conversion last month.  I think the level of NPLs at that bank make it less attractive since downside is greater.  There are others that have better loan performance and are overcapitalized.  Their earnings power is low, but the asset quality is strong and are far more valuable than the current market capitalization.  An issue not specific to Wolverine is the liability side comprised of advanced from the Federal Home Loan Bank (FHLB) and deposits.  Advances from the FHLB are a high cost source of funds.  Many of the smaller thrifts have relied on time deposits to attract funds, which are considered lower quality since these tend to flow to wherever is offering the best interest rate.  There are still plenty of banks with core deposits comprised of sticky accounts like checking and savings though.  There is value in these above tangible book value because an acquirer would pay extra for the deposits it would have to pay a lot to acquire through incentives.  That's why you see the megabanks offerings cold hard cash for you to open an account with them.

I haven't really looked at the megabanks, but I have seen some prominent investors tout BofA as cheap.  Jeffrey Gundlach sounded off BofA as a proxy for an echo in the housing bust.  The video is more worthwhile than the article.  He is one articulate guy who backs his ideas up with solid facts.  He makes a very pertinent point about BofA holding tons of subprime loans that are still souring and have worse and worse recoveries.  This opens up the potential that the entire principal on the loan gets written off.  It will be interesting to follow for its broader ramifications on confidence in the rally, but will prove immaterial to the value of many of the thrift conversions since they never wrote poor quality loans.  At the same time, it may push out the timeframe for when the market reprices the banking sector.

An interesting bank stock

Wayne Savings Bancshares is plain vanilla bank with plenty of capital, a good dividend, and a strong deposit base.  Wayne operates through 11 branches in northeast Ohio.  Unlike most banks still working their way through poor loans and repairing their balance sheets, Wayne is healthy with a modest ratio of non-performing loans and strong earnings.  Wayne is well positioned to return more capital to shareholders through buybacks and dividends, and the presence of an activist investor might help unlock this catalyst. 

Wayne trades at 80% of tangible book value and 68% of book value and 11x earnings.  The main problem with valuing a bank is that the numbers are susceptible to manipulation through provisioning and allowances for losses, which fall largely to the discretion of management.  The greatest danger is waking up one day and realizing that the bank is going to take one huge hit on loans that they knew had been souring in prior reporting periods à la Citigroup.

Wayne has $13.6m in total non-performing, impaired assets, and loans past 30 days, which is a wide proxy of things that can go wrong with the balance sheet.  Against $33.7m in tangible capital, $3m in allowances and assuming 25% recoveries on all bad assets, that leaves $26.5m in tangible capital, which would still be above the regulatory definition of “well capitalized” and is marginally higher than the market capitalization.  The bank is earning about $2.8m in pretax pre provision income annualized right now.

Put into the context of the loan book, these broadly defined “bad assets” amount to 5.7% of the loan book and 3.3% of total assets, although some of them are not delinquent (yet?), being renegotiated, or are already in the process of being liquidated to cover the principal.    Non-performing loans were 1.7% as of Dec 2010, which is within reason and about average for peers. 

Funding – the importance of which 2008 really highlighted – is what makes the bank attractive as a potential takeover candidate.  It has a 50/50 split between sticky or low cost deposits with $62m in demand deposits, $101m in savings and money market deposits, and $155m in time deposits (CDs).  The chairman is in his late 70s and the CEO is 65, which makes me wonder if the bank has a greater likelihood of being sold than your average local bank in a similar position.  The presence of Joseph Stilwell, (not to be confused with Vinegar Joe Stillwell, a feisty US general who romped around the Asia-Pacific theater in WW2) an investor – oftentimes activist- who has filed a 13-D in regards to WAYN, might push this process along.  In Item 4, Stilwell lists many of his past investments in small banks.  If you read the summaries of his older investments, many of them sold themselves fairly quickly after his involvement.  In the case of WAYN, it is not his stated purpose, but it seems possible.  The filing states:

“Our purpose in acquiring shares of Common Stock of the Issuer is to profit from the appreciation in the market price of the shares of Common Stock through asserting shareholder rights.  We do not believe the value of the Issuer’s assets is adequately reflected in the current market price of the Issuer’s Common Stock.
 We hope to work with existing management and the board to maximize shareholder value.  We will encourage management and the board to pay dividends to shareholders and repurchase shares of outstanding common stock with excess capital, and will support them if they do so.  We oppose using excess capital to "bulk up" on securities or to rapidly increase the loan portfolio.  We will support only a gradual increase in the branch network.  If the Issuer pursues any action that dilutes tangible book value per share, we will aggressively seek board representation.”

One might read through the lines and think that asserting shareholder rights to have the market price reflect the value could entail an acquisition.  If that were the case, this would be a situation where you could say “heads I win, tails I don’t lose.”

The bank does seem to trade at a discount to what is likely tangible book value when the smoke disappears and it is earning strong returns to justify trading at tangible book value at the minimum.  The TBV is greater than the market price, although not by much.  The upside is only 33% if the reported tangible book value is used.  One might argue it is worth a premium to TBV since the deposits have franchise value.  The problem is that the real attractive upside would be in a buyout scenario, which is feasible considering the consolidation in the industry.  To the extent of publicly available information, such a scenario is entirely predicated on the actions of one individual not directly involved in the company.  As such I’m standing on the sidelines for this, but this its an interesting stock to follow and see how the balance sheet act in the coming quarters.


Disclosure: none

Full House Resorts Update

I’m glad I did an in depth breakdown of my FLL thesis, because there are some things I did that turned out to be grossly wrong.  Luckily, I knew in the back of my head that I wasn’t going to hit the nail on the head so I tried not to overreach on assumptions.  My numbers for the FireKeeper’s contract were way too low, but I missed the boat on the Grand Victoria acquisition almost entirely in terms of deducting the EBITDA or EBIT figures.  While I think the company is less undervalued now that there is more light on the Grand Victoria acquisition, there appears to be less downside risk. 

The bulk of the thesis was that on a sum of the parts, peer, and absolute valuation the company was undervalued.  To redo a back of the envelope SOTP calculation, Stockman’s is worth $14m (7x EBITDA), Grand Victoria is worth $43m (purchase price), and the GEM contract has a NPV of ~$40m ($10m annual payments through August 2016 with a 10% discount rate - management finally broke that out in the most recent earnings announcement) with $21.5m in net debt for a net value of $75.5m.  I think this represents the prices that would be received if the company liquidated tomorrow in an orderly fashion. 

This isn’t a huge discount to the current market price, but that partially hinges on valuing the Grand Victoria acquisition.  Full House purchased the asset for 5x EBITDA, so it would defy rational thought to expect the market to turn around and apply a 7x EBITDA multiple to it.  Recent developments indicate that Grand Victoria’s results might prove more resilient if not stronger relative to the past.  My initial take was that the GV acquisition price implied that management was pricing in a huge drop in revenue and earnings.  This turned out to be wrong.  Hyatt Gaming, part of the Pritzker business empire, has been trying to sell the property for several years not, not just in light of upcoming competition from Cincinnati.  I also totally messed up deriving the EBITDA and earnings of GV.  Grand Victoria generated about $8m in EBITDA in 2010, not $8m in net income as I assumed.  With that disclosure by management though, it also appears that the $8m EBITDA figure is going to be more attainable in the future.  The closer to the $8m figure Full House is able to achieve post 2013, the higher valuation the market will accord to the property (closer 7x+ EBITDA instead of the paid 5x).  The nice thing is that even if this doesn't happen, the price paid might end up being close to 7x normalized EBITDA.

One thing discussed on the conference call was Indiana passing legislation to reduce the required maritime crews on riverboat casinos.  Previously, despite remaining permanently moored, casino riverboats still had to meet regulations for water vessels.  The Indiana Gaming Commission has to approve the casinos actually reducing such staff.  If the staff reductions are approved, starting July 1, 2011, Grand Victoria’s costs will be reduced approximately $1m according to management.  There are tweaks management is making as well, such as converting more hotel rooms into suites.  The 2010 EBITDA of $8m compared to 2010 wins of $100m(IGC figure, doesn’t include hotel, food, or beverage revenue) implies 8% EBITDA margins, which is low.  Assuming a lower market share of 10% of wins (currently 14%) and the $181m drop in casino revenue projected to be taken from the 3 Indiana riverboat casinos from the casino in Cincinnati, the Grand Victoria would still generate $4m in EBITDA or 10.5x its purchase price. 

The downside risk from that scenario coming to fruition is not only limited by the already demonstrated opportunity to lower operating costs, but what now appears to be wrangling over the terms of the Cincinnati casino.  Currently, construction has stopped on the site as the owners and government officials argue over tax rates.  While it will likely just push out the opening date a few months, it gives management more time to maximize unnormalized earnings until either very late 2012 or early 2013.  Indiana is also going to try to keep the casino owners investing in their properties to continue to attract patrons and tax revenues as a result, as evidenced by the maritime crew changes.  This is just gravy, but it will help the business.  

This could just be narrative fluff, but I have considered an additional benefit of the Grand Victoria acquisition that is being ignored.  After talking to a young guy living within the market of the Grand Victoria who enjoys gambling, I realized that the opening of the Cincinnati casino will likely have a disproportionate effect on the revenues of the 2 larger riverboat casinos it competes with – Hollywood and Belterra.  The person I spoke to laughed when I mentioned the Grand Victoria and said that he would never go there.  He and his friends prefer the Hollywood Casino, which is far bigger and glamorous.  That demographic – the ones preferring the glitz and glamor of the casino as a nighttime/weekend outing option over a simple place nearby to gamble after work or during the day – is going to flee the casino that currently suits their taste for the even more glamorous Cincinnati casino.  I can’t quantify this and only time will tell if this translates into stronger revenue and earnings. 

Another tidbit mentioned on the conference call was the potential for additional management contracts.  The FireKeepers management contract has been producing 64% EBITDA margins, which is incredibly high.  This has attracted the attention of casino managements (including bondholders) trying to turn around their operations.  FireKeepers has given Full House a very good piece of proof to tout if approached over a management contract.  This isn’t anything to bank on, but it does present additional upside since it would require little capital and generate a lot of cash flow.  It is also worth noting that FireKeepers has experienced practically no negative effects in light of the opening of the Gun Lake Casino.

One worrisome development was the approval of a motion to increase the number of authorized shares for the company.  Full House did use a stock offering to partially finance its acquisition of Stockman’s, which didn’t result in the share price falling much.  Management stated that they have the capacity to announce another deal by the end of the year, but it wouldn’t be completed until 2012.  They provided some further light on what they would look for in an acquisition, namely a low multiple and management already in place.  While it bears consideration, this risk is mitigated by the intelligent acquisition of Stockman’s and Grand Victoria.  While acquisitive management can be worrisome, management hasn’t done anything stupid in the 5 years it has had an acquisitive stance.  On the face of it dilution would be a negative due to what I perceive as an undervalued stock, but a stock offering to finance acquiring an undervalued property would net out the effect while providing a more diversified earnings stream that would be more highly valued.  The current environment is filled with distressed or heavily indebted casino owners (Harrahs/Ceasers, whatever they call it) and tons of peers have high leverage ratios.  They also have tons of excess cash from the FireKeepers contract including debt service, so there is also the potential that cash will be a large component of future acquisition and either modest additional debt or modest share issuance will finance the remainder.  The combination of Full House's modest leverage, rock bottom interest rates, and a distressed environment increase the likelihood that any acquisition will be a net benefit.

Additionally, here is an interview with the CEO about the company from 2004.  It’s outdated, but gives some nice background on the company if you are interested. 

It might be tenuous to count the FireKeepers contract as traditional EBITDA (although all the proceeds drop through to net income) but Stockman’s and Grand Victoria are generating about $10m in EBITDA right now and FireKeepers is generating at least $10m in FCF.  The stock trades at an EV/EBITDA+FCF of less than 5x compared to the 7-8x range of its peers, many of which have higher leverage ratios.  The core thesis that the uncertainty regarding Grand Victoria is causing the market to ignore the earnings power of the business remains intact, albeit with a slightly lower upside potential.  In addition to upside from business as usual though, newer catalysts that aren’t priced in or crucial have emerged in the potential for additional management contracts or much better Grand Victoria results than expected.  

Disclosure: Long FLL

Exotic ETFs - the innovator, the imitator, the idiot

Warren Buffett has been quoted saying something along the lines of every idea goes through 3 stages; the innovator, the imitator, and the idiot.  The ETF idea went straight from innovator to idiot.  Frankly, ETFs have always been a dumb idea after they created broad based ones that followed broad indices.  The implicit benefit behind the creation of an ETF has always been low cost access to the broad return of the market.  That's simply no longer the case.  A Russell 2000 or S&P 500 tracking ETF is an investing vehicle that intuitively and empirically makes sense.  All of these alternative energy, Brazil this, China that, triple leveraged future gold or oil and all these new derivative ETFs are a fee driven perversion of a simple idea that was beneficial to markets.

This paper by the Financial Stability Board says it all in more diplomatic and eloquent tone as well as warning about all the danger that lies ahead as these products are traded in more volatile markets.  Obviously this will turn into the black swan of 2013 or whatever "oh, shucks" nonsense the media, financial industry, or politicians/"regulators" cook up.  That isn't sarcasm, that's cynicism.

The paper focuses on the increasing innovation in the industry, which I would call blatant idiocy.  The real innovation was creating the plain vanilla funds that broadened access to liquid, tax efficient ways for passive investors to achieve better returns than through handing it to mutual funds.  All the other stuff is just an excuse to take your money.  If you have the capacity to establish X industry is going to do well or is undervalued, why not take the extra step and identify the companies that will really win?  I like what some investors are doing with buying baskets of large cap tech like Microsoft, Cisco, and Dell, but a tech ETF would leave you owning plenty of unsavory names.  If you can't do that work, just stick with the broad based ETFs because you probably couldn't articulate an objective data driven thesis on the industry anyways.  I digress.  The paper is short and filled with fairly easy to digest analysis on where it can all go wrong.

On financial stability risks from exotic ETFs:

Among recent innovations, a specific trend warranting closer scrutiny is the recent acceleration in the growth of synthetic ETFs on  some European and Asian markets. In this type of ETF, the provider (typically a bank’s  asset management arm) sells ETF shares to investors in exchange for cash, which is then invested in a collateral basket, the return of which is swapped by the derivatives desk of the same bank for the return of an index.  Since the swap counterparty is typically the bank also acting as ETF provider, investors may be exposed if the bank defaults.  Therefore, problems at those banks that are most active in swap-based ETFs may constitute a powerful source of contagion and systemic risk.  

I know I said the analysis was fairly easy to digest and maybe I lied, but I promise most of the paper isn't like that.  The paper continues to note the misaligned interests of banks being in this position.  They note additional fee sources, such as securities lending that are another reason why the creators love these things.  These funds make more money on securities lending than from the management fee on the ETF itself.  The asset management arms of companies use their own parent company trading desks as counterparties for derivatives which is a complete fee-fest.  If this has ignited your interest, I recommend reading the full paper.  It's short and you will be more aware of downside that people will say nobody saw coming whenever this blows up.

There's likely a bunch of money to be made in profiting from this all blowing up.  I don't know enough about the plumbing of the financial system to figure out where it will all go sensationally wrong, but c'mon, how could this not go horribly wrong?  For now, I'm sure the "innovators" are minting money.  The only bet I would make is that in +/-2 years, there will be some Propublica on Magnetar-esque epic documentation of the ETF industry equivalent.  Maybe it will resemble more AIGFP.