Description

Butler National Corporation (BUKS.PK) is a small $35 million market cap company with a peculiar mix of businesses that on the whole appears quite cheap.  Right now the market doesn't recognize the coming profitability of the combined group due to accounting peculiarities.  The company has the following five segments:

• Aircraft Modifications
• Avionics
• Gaming
• Monitoring Services
• Corporate / Professional Services

The first three business lines are the key drivers of the group, with the gaming segment being what the market appears to be missing.  The aircraft modifications business is a service business that involves making structural and non-structural changes to mostly older small aircrafts.  Much of this business is so-called special mission work.  The avionics business is a manufacturing business that makes a variety of electronic systems and components.  The gaming segment is involved in the managing of Indian and state-owned casinos in the Midwest.  The services businesses are small operations involved in monitoring and repair of water systems in Florida and the provision of architectural services.  Admittedly, this is an odd mix of businesses.

The key to the thesis is the gaming division.  For over a decade the company has managed a casino for the Miami and Modoc tribes in Oklahoma.  More key to the thesis though is that several years ago the company was an instrumental party in supporting gaming legislation in Kansas.  The resulting legislation provided for four state-owned casinos that would be managed by private entities.  Not too surprisingly, Butler was chosen as the manager for the state's southwest casino in Dodge City.  The company financed the entire project with very little capital.  Prior to being announced as operator, the company purchased some land in Dodge City for approximately $2 million.  It brought in a real estate partner to buy a portion of its land, build the casino and own 40% of the management company.  Butler sold the land for approximately $2 million and now owns 60% of the management company for essentially no net capital outlay.

While there are several casino management companies that are public, it is my belief that the model with the state of Kansas is significantly different from those companies that manage Indian casinos.  First, in this case, the private enterprise (Butler's partner) owns the real estate in which the casino operates.  Secondly, these management agreements are for 15 years.  It would seem unlikely at the end of those 15 years that the state might go with another operator, as it simply does not own the real estate.  Perhaps the economics might change, but the state would have to convince another operator to build another casino property.  You can read the contract here http://www.kslottery.com/ExpandedLotteryAct/ContractsSWZone/SWZoneContracts.htm.  Butler opened the casino in December 2009.

This is where the Butler thesis becomes interesting.  After the casino opened, Butler's revenue grew dramatically, but profitability from that growth appeared to be non-existent.  This was due to some peculiar accounting and ownership legalities.  The state law dictated that the private manager could not own the gaming equipment.  It had to be owned by or leased to the state.  Butler decided to purchase the gaming equipment on behalf of the state.  Butler could not book the assets to its balance sheet and so ever since the casino opened, Butler has been paying the state back for the purchase of the gaming equipment from the cash flows of the casino.  It has been booked as a reduction in revenues.  Based on comments from the company, this should be ending in the June or July timeframe.  Essentially, Butler has reported a reduction in revenues that is capital spending.  The magnitude of the peculiar situation is significant to Butler, as the company estimates that this will result in additional net income of $200,000 to $300,000 per month or $2.4 million to $3.6 million for a full year.  This is for a casino that is not yet at maturity.  There is currently no hotel on the property, though construction on the lodging should begin this year.

In relation to the casino, the company has some interesting real estate development options.  Originally as mentioned, it purchased $2 million worth of land.  This included approximately 400 acres, 100 of which Butler later sold to the real estate developer.  After the exercise of an option for approximately $700,000 for an additional 100 acres, Butler owns the 400 acres that surrounds the casino property.  It intends to develop this property as time goes on.  While I'd say this is valuable land, especially in relation to the fact that Butler owns the 400 acres with a cost basis of approximately $700,000, it is anyone's guess what this could be worth.  I consider any value generated by the land to be icing on the cake.

The following excerpt from Buter's most recent conference call provides some background support for the implications of the accounting treatment I described, future profitability, and the interesting valuation:

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Operator

And our first question comes from Ed Steffon.

Analyst

I'm interested in the paying down on those machines. I had thought that, that might happen sooner than June or July.  And can you comment a little bit on what that amount is? And...

Clark Stewart

The total amount is around $10 million.

Analyst

How much a month is that?

Clark Stewart

It's roughly -- it's a floating number. That's about 20% to 21% of the revenue, so it depends on the casino revenue, how fast we pay them down. We have paid off two of the five vendors already, and that's because their machines perform maybe a little better than some of the others. And the rest of them, it will draw on out through that time period. So it's a variable number. I couldn't tell you exactly what date we're going to be there, but that's how it works.

Analyst

And that's in the neighborhood of about $600,000, $650,000 a month?

Clark Stewart

That's correct, yes.

Analyst

And when that's paid down then, those -- that amount or some portion of that would go down to earnings, right?

Clark Stewart

Well, yes, it would. The difference is, is that as time passes, we expect to have to replace about 20% to 25%. So over the future, we'll spend a couple million dollars per year on replacements to keep the floor fresh and all that kind of thing. But it won't ever be at $10 million, Ed. It will about 20% of that $10 million.

Analyst

So we should see some significant improvement in earnings going forward once these are paid down.

Clark Stewart

You should see that. That's correct.

Operator

Our next question comes from David Elfenbein from UBS.

David Elfenbein

Looking forward, I got a little confused by when you said revenue for this year and next year in terms of for the April fiscal. Can you just go over those numbers again that you had mentioned?

Clark Stewart

Yes. We've got about $33 million through the -- $33 million through the nine months. So we figure we'll have over $40 million this year. We'll have another $7 million, $8 million, maybe more than that, I think. We calculated $43 million at the shareholders' meeting. We didn't bring a number like that to it but that's where we were, and I don't know that we'll be quite that strong. I'd say it's somewhere between $40 million and $45 million for April 30. And then, of course, the next year, we expect that to grow more close toward $50 million. Some calculations say it's well over $50 million; some say it isn't. So I'm just telling you it's pretty broad range. But the casino is up about 15% right now this year over last year. Sometimes, we think it might even be higher than that, but it's really strong. We've increased the marketing efforts substantially, and it's generating pretty good revenue for the state. So the answer to your question is somewhere between $40 million and $45 million and somewhere around $50 million for next year and maybe more than that.

David Elfenbein

Okay. And should we expect at least -- exclusive of the gaming piece which you guys just talked about, should we expect similar margins across the rest of the business segments?

Clark Stewart

Yes.

David Elfenbein

So all else being equal, I mean, if we're going to do $2 million to $3 million of net this year. And let's just say -- I mean, is it reasonable to assume you'll get an extra couple few hundred thousand dollars of operating profit a month once those machines kick through? Once you no longer...

Clark Stewart

You got to remember we got a 40% partner. So you're looking at, yes, $200,000 to $300,000 is probably a pretty fair number.

David Elfenbein

Okay. So you're looking at another $2.5 million to $3.5 million dropping to the bottom line plus whatever growth metrics happen in the business in addition to $200,000 to $300,000.

Clark Stewart

That's correct. Now that's a little scary. We might make $5 million. That will scare me to death, $5 million after taxes. I don't know that I can pay that much tax, anyway.

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So taking the company at its words from the conference call, it would appear that the company is trading at between 6.2 and 7.2 times the twelve month net income beginning in June or July of this year. 

In my opinion, especially considering the quality of the management agreement, the room for growth at the casino, and the additional assets on the company's balance sheet, 6 or 7 times is too cheap.

To contemplate the upside, if you said that the company would be trading at 13 times trailing earnings by the end of the 12 months beginning in July, the upside would be nearly 75% with no growth in earnings and taking into consideration the management incentives mentioned below.

Another way to look at the valuation is that if you put a 10 times multiple on the company's shares of net income from the casino (using mid-point of $3 million), you get $30 million.  So for $5 million you could get a collection of businesses that generated a bit more than $5 million in operating income over the last twelve months.

Management Incentives

Late last year the company announced a new option incentive package that would result in the granting of shares representing 12.8% of the current share count.  While a fairly large number, the design of the program is interesting.  With the stock below $0.50 at the time, the shares can be exercised in three separate but equal tranches once the stock hits certain levels.  The three levels are $0.92, $1.41 and $1.90.  12.8% is a large number of options in my opinion but the design of the program clearly only allows executives to win big if current shareholders win big.  If the program is any insight into where the company thinks the stock is going, current investors will be well rewarded.

Planes

The company owns several small aircraft.  It purchased these planes over the last several years, some at prices far above current market prices.  While the company is not seeking to be a fleet owner, it was and still is seeking to become certified on certain model planes for its modifications and avionics businesses.  Some of these plans required rapid depreciation as market values declined.  I don't think the company will get carried away with buying more planes but you never know.  In fact, management has indicated that it is attempting to sell several of the planes it owns.

Also, as most of the executives are pilots other worries surface.  Executives do fly company planes to their operations throughout the state and elsewhere.  Concerning for the equity investor is the cost of this transportation and any situation in which a plane full of company executives crashes.

Casino Maturity

It would appear that there is ample room for improvement in the financial profile of the casino, aside even from the accounting mentioned previously.  There are no hotels on the property at this point, though that appears to be something that over the next 12 months should change.  Also, there is little other development around the casino aside from a convention center that the city recently built.  Additional shopping and dining options in addition to the hotel should prove to be a catalyst for the property's growth.

Additional Casinos

As mentioned, the state legislation called for four casinos.  While one of the four has not yet been bid on and is likely not to be built due to local market conditions, there are two more casinos which over the next 18 months should be constructed.  The casino that Butler manages is in the far Southwest of Kansas and though it does draw some people from Wichita is should have its own "geographic franchise."  Nonetheless cannibalization is a risk to consider.

Future Listing

Though the company is traded on the Pink Sheets it is fully SEC reporting.  It files Q's and K's like any registered company and so disclosure is superior to other Pink Sheet companies.  Additionally, the company has indicated that it intends to seek a listing in the not-so-distant future with the share price being the primary hurdle at this point.

Acquisitions

If you listen to the entire call I reference, you will clearly hear that the company has its eyes on acquisitions.  These acquisitions are targeted toward the avionics and modifications businesses.  Obviously, any poor decisions in this regard wouldn't help equity holders.

Liquidity

Some days are better than others.  The ten day average volume is approximately 50,000 shares.  The liquidity can be an issue.

Non-Gaming Gross Margins

The gross margins in the non-gaming business are interesting.  Generally the avionics business, while somewhat erratic, has hovered around 50%.  In the aircraft business, margins have now improved over the last few years into the low 40's.  Management attributes this to improved throughput / utilization and scheduling resulting from R&D efforts in the early years referenced above.  It would appear that one risk facing the equity holder is the GM at the modifications business returning to 2009 and prior levels.

Legislation

Theoretically, the state of Kansas, which enacted casino legislation, could enact countering legislation at some point in the future.  While the Butler and their partner would be entitled to at least the $5 million earnest money originally paid to the state, this would reduce a significant component to the upside.  I have a hard time imagining the state removing legislation which reduces what could become a significant state income item, but its is possible.

Catalyst