JakilaTheHun (99.93)

Isle of Capri Casinos: An Intriguing Case in Valuation and a Good Red Thumb

June 24, 2009 – Comments (7) | RELATED TICKERS: ISLE

Isle of Capri Casinos is an intriguing case in equity analysis. I became interested in this after seeing the chart showing the huge run-up. Still, it's historically cheap by levels in 2006 and 2007; but we all know by now that those levels were based on sheer fantasy.

It is my belief that "the market" is normally wrong on various issues relating to valuation. ISLE is interesting to me because it might be suspect to two divergent mispricings: (a) the underpricing of companies with significant real estate holdings and (b) the shifting macroeconomic view on casinos which suggests that maybe casinos are not as bad off as thought back in November '08.

Despite the casino run-up, many of the casino stocks still look relatively cheap. I have very negative macroeconomic views on them, but would not recommend most of these stocks as underperform picks or shorts because there are huge risks in taking a decidedly negative investment action on stocks priced near bankruptcy-levels. What makes ISLE more intriguing as a red thumb is that it is no longer priced for bankruptcy. In fact, it's priced for relatively strong growth and recovery.

The Financials

The first thing to analyze with ISLE is their balance sheet. It is U-G-L-Y! ISLE is levered to the tilt, has very little equity, and even that equity figure is propped up by a huge amount of goodwill and intangible assets. For the record, goodwill is pretty much worthless and ISLE's particular intangibles (mostly gaming rights) are worthless if their business is failing. After my own adjustments, I come up with a modified book value of (-$4.15) per share.

Next items to analyze are earnings and cash flows. Earnings for ISLE have not been overly impressive over the past three and a half years and even some of their good quarters are propped up by one-time items ("hurricane insurance recoveries"). Once you ignore those one-time items, ISLE has been unprofitable as of recent times based solely on income statement numbers.

HOWEVER, this is where things get tricky. Remember that ISLE has a large amount of real estate and property holdings. And guess what --- those items incur large depreciation charges that are non-cash and don't represent anything substantive moving forward since property values have a tendency to rise over time. But then, that issue becomes even trickier, because their casino properties are often found in locales where it's unlikely that any businesses would have significant use for their properties aside from using them as casinos. As an investor, I'm more fearful of assets with circular valuations --- that is, they are worth XX amount so long as they remain profitable, but are worth virtually $0 otherwise.

So, with all that said, I decide to try to come up with an optimistic normalized free cash flow forecast for ISLE. I came up with $1.27 per share based on all my adjustments, but I also ran scenarios with $1.52 per share and $2.00 per share.

Costs of Capital?

There's yet another issue with ISLE. Costs of capital are difficult to ascertain. They have traditionally been able to obtain financing with interest rates in the 6% - 8% range, but I felt the company was somewhat misleading in their financial statements. They state a weighted average cost of capital for FY '07 + FY '08, as if this is a meaningful statistic.  ISLE seems to go out of their way to be a bit ambiguous on their most recent financing activities.

Given this, I have no clue what their cost of capital might be. Based on a 7.75% weighted average for debt, I might use a 9.5% total cost of capital figure; except, I get the feeling that this might be low moving into the future, especially when you consider how much debt ISLE is burdened with. I'll run my DCFs with 9.5%, but I leave open the possibility that this figure could jump from anywhere from 10.5% to 14%, which would significantly hamper their operations.

Valuation

Now, with all that said, my probable-optimistic forecast based on the $1.27 free cash flows with a 3% long-term growth rate is $14.90. In order for this to hold up, there are substantial macroeconomic and cultural assumptions that need to be met and I do not believe they will hold up. Therefore, given this and given the fact that I believe the rest of the market is more than 20% undervalued, I will go with underperform on this.

However, keep in mind there are substantial risks with shorting this. My more optimistic forecasts that give ISLE considerable growth and assume macroeconomic improvement suggest the stock could be worth from $18 to $26 --- a significant increase from current levels. All the same, downside risk on this is $0 and I believe given the risks, uncertainty, and macroeconomic climate, it is worth closer to $7.

Overall, I think this is a good red thumb pick.  My level of certainty behind this is low, but I want to continue to test my ability to pick out overpriced stocks.  I have red thumbed this on my JakilaTheHunII profile. 

Dissenters Speak Out

As I've said numerous times, my main objective for playing CAPS is to learn more about investing, companies, and particular sectors of the economy.  If there are any dissenting opinions, I'd love to hear them.  Why might I be very wrong on ISLE?