Fructivore Investments

Those of you who have been following my articles on the River Rock casino bonds will recall that they fall due for refinancing in November of this year, and that this refinancing process has been delayed because the casino is negotiating its agreement with Sonoma County. If you haven’t been following my articles, that should pretty much bring you up to date.

The agreement with Sonoma County required River Rock to build an emergency access road, and also to pay to the county $75 million by 2020 in order to address the increased usage of county resources caused by a planned expansion of the casino. Now that the expansion has been put on indefinite hold, it would seem that the county requiring the full $75 million would place an undue burden on River Rock’s finances and also be unfair.

The River Rock Entertainment Authority has renegotiated the agreement, cutting the required payments from $5 million per year, increasing by four percent annually, to a flat $3.5 million per year. However,  if the expansion does open River Rock will have to make such additional payments as to bring the total payment (including the $10.3 million already paid) to $75 million, and at any rate the full $75 million must be paid by 2020, subject to future negotiation. Furthermore, the Authority also secured an agreement to build the road on an alternate site, which is now in escrow, and which allows for a 20% grade instead of a 10% grade, a change which the casino estimates will save up to $15 million.

So, now that the $75 million obligation has been deferred, which reduces its present value, and the road savings plan is looking more definite, it would appear that River Rock is a more attractive prospect from the perspective of a bond buyer. Based on last year’s free cash flow figures, and treating the $3.5 million annual payment as a fixed charge, the casino has a fixed charge coverage ratio of 2.5x, as compared to 2.3x before the renegotiation, which is a more attractive situation. Also, the River Rock Entertainment Authority has $43 million in cash on its balance sheet, which, if the new road plan goes through, would be more available as a source of liquidity or simply to pay back part of the bonds. As result, it should be easier for River Rock to refinance.

The market seems to greet this renegotiation with approval; prices have improved to around 92 from generally 88 before the announcement (as a reminder, the bonds were at 84 when I recommended them). River Rock now has a clear route to refinancing (and not too soon, I should note, as refinancing bonds seems to be a months-long process). I still find this issue attractive and find it highly unlikely that there should be no refinancing.

Cal-Maine Foods (CALM) is one of the largest egg producers in the United States, with a market cap of roughly $675 million. Of this, $213 million is represented by excess cash and short term investments, and the free cash flow yield on the balance is roughly 16%, or 15% when considering average profit margins over the last five years.  Although egg prices are highly sensitive to supply, Cal-Maine has been expanding specialty eggs as a portion of gross sales. Specialty are organic, cage-free, etc., and more importantly are both less sensitive to supply and offer higher profit margins.

Please my full opinion on Cal-Maine at

http://seekingalpha.com/article/271363-cal-maine-foods-profit-opportunity-in-the-egg-business

I was sick last week, but I have returned and I brought a promising microcap company called Servotronics (SVT) with me.

Servotronics is a small company; daily volume averages only about 1200 shares, but it offers excellent figures. It operates in two sectors, one of which is, obviously, making servos such as torque motors, electromagnetic actuators, and valves for use in the aerospace and missile industries. 21% of Servotronics’s servo sales in 2010 were made, directly or indirectly, to the US government. Servotronics’s other sector is the cutlery business, from cooking knives to utility knives to machetes and bayonets. 21% of Servotronic’s 2010 sales of cutlery were also to the US government, although this is down from 28% in 2009.

The balance sheet of Servotronics is attractive; almost in a net-net situation. The company has a market cap of $18.8 million and has $4.4 million in cash, $5.4 million in receivables, and $11 million in inventory, total $21 million, set against $7.2 million in total liabilities. At any rate, because noncash current assets cover current liabilities (in fact, they cover total liabilities), the cash on the balance sheet can be considered excess.

In terms of earnings, in 2010 sales were $32 million, reported operating income was $3.1 million, excess depreciation was $160 thousand, producing operating cash flow of $3.3 million. After interest expense of $74 thousand, and taxes of 35%, we have free cash flow to equity of $2.1 million. Based on the current market cap this is a free cash flow yield of 11.1% before excess cash is taken into account, or 14.6% when the excess cash is taken into account. The company has very low interest rates because the bulk of its long-term debt, $3.1 million, consists of Industrial Development Revenue Bonds issued through a government agency and carrying an interest rate of .54%. Given Servotronics’s sensibly modest use of debt, I do not anticipate the situation will worsen when the bonds fall due in 2014.

In 2009, sales were $33 million, reported operating income was $2.6 million, excess depreciation was $118 thousand, producing operating cash flow of $2.7 million. After interest expense of $84 thousand and taxes, the company produced $1.7 million in free cash flow.

In 2008, sales were $34 million, reported operating income was $4.7 million, excess depreciation was $42 thousand, producing operating cash flow of $4.8 million. Interest expense was $178 thousand, and after taxes we have a free cash flow of $3 million.

In 2007, sales were $31 million, reported operating income was $3.5 million, excess depreciation was $66 thousand, producing operating cash flow of $3.6 million. After interest expense of $255 thousand, and taxes, we have free cash flow of $2.1 million.

As we see, then, the earnings history of Servotronics is reasonably stable, which gives us confidence that the free cash flow figures are a reliable indicator of a company’s future earnings power. Servotronics also pays a modest annual dividend of 1.6%.

I do need to address, however, the liquidity aspect. Obviously, it would be unwise to use market orders instead of limit orders, but even so, market participants place an importance on liquidity and may insist on a higher return from microcaps like this one. Damodaran, in his useful Damodaran on Valuation, estimates that this premium could reach 30% or more, although many of his examples are drawn from private equity firms, where the market is nonexistent, rather than the stock market where the market is simply thin.

As for this matter, I would first remind us all that liquidity is often an illusion, as we discovered with auction rate securities in 2008, and furthermore, I am reminded of what Ben Graham said about liquidity in his Security Analysis, that it is the sine qua non of speculators, while investors, who if they follow sensible financial policies will hardly ever be forced by circumstances or margin calls into liquidating in a hurry, should find liquidity of secondary concern to value. Even so, the bid-ask spread for Servotronics, from what I’ve observed, can be 1-3% of the share price, which can be a difficult hit even when spread over a long holding period.

At any rate, I find Servotronics to produce stable earnings that are ample relative to the company’s price, and with a little caution and trading skill, one could easily build a position that can produce satisfactory returns.

I recently examined Revlon (REV), a makeup company which has had a spotty and debt-laden history but which has turned the situation around in the last four years, assisted by substantial overseas growth. Although the firm is still dealing with the debt that Ron Perelman saddled it with during its LBO, it offers a free cash flow yield of more than 10% when its tax loss carryforwards are taken into account, and Ron Perelman seems to stand ready to serve as an (expensive) lender of last resort.

For my full views on Revlon, please visit

http://seekingalpha.com/article/266582-revlon-positive-operating-trends-and-a-low-valuation

It was announced yesterday that Smart Modular Technologies (SMOD) would be taken over by a private equity firm for $645 million, or $9.25 per share. When I recommended it here on January 3, the price was $5.94. Not bad for a few months’ wait, I think.

As you may know, my favorite metric for evaluation a company is its ability to generate free cash flows. However, it is dangerous to focus entirely on that issue to the exclusion of other important aspects of a company. I will explore this issue by examining Lodgenet (LNET), a company with free cash flow through the roof, but with certain offsetting characteristics that make it an unattractive prospect to me.

Lodgenet’s business is providing media and connectivity on demand in hotels, and they are also expanding into hospitals. The majority of the company’s revenue comes from guest on-demand movies, including what are described in the SEC filings artfully describe as “independent films, most of which are non-rated and intended for mature audiences”. Lodgnenet also provides ordinary cable programming and broadband Internet service, which it supplements with advertisements.

The company’s numbers are phenomenal; in 2010 the firm’s free cash flows were $50 million, although because much of that comes from excess depreciation, the firm’s earnings power would be about $32 million if excess depreciation was taxed. Lodgenet has 10% preferred stock outstanding, which has a prior claim of nearly $6 million per year, and I shall have more to say about the preferred stock later. Even so, the company’s market cap is only $90 million, so depending on which tax treatment is chosen, the company has a free cash flow yield of 30.3% under the high tax scenario, or 48.9% under the low tax scenario. In other words, in a little over three years, based on current earnings power, Lodgenet would earn a purchaser enough in free cash flow to pay off the shares.

But could it, really? I am concerned that this may be too good to be true. Lodgenet’s sales have been declining for some time, and the firm has a massive debt position that raises concerns about interest coverage and covenant compliance. The preferred stock that I mentioned was issued in June of 2009 in order to equitize a portion of Lodgenet’s debt (as well as provide some anti-takeover provisions) and there was a stock offering in 2010 that had the same effect, although the firm claims that part of the proceeds were used for capital spending as well. In the first quarter of 2011 Lodgenet also refinanced its debt agreement, expanding its permitted leverage ratio from 3.5 to 4 and reducing its interest coverage ratio from 3x to 2.25x in exchange for an increase in interest rates, which are estimated to be 6.5% (5% plus LIBOR, or plus 1.5%, whichever is higher) on a forward-looking basis, apart from a brief spike next quarter before Lodgenet’s swaps expire.

Furthermore, 2010’s capital expenditures, at $22 million, are well below the five-year average levels of $47 million. Now, as is stated in Benjamin Graham’s Security Analysis, a company can only be said to have earned money if it has made sufficient capital expenditures to maintain its earnings power. Damodaran, in his useful toolkit Damodaran on Valuation, reminds us that there can be a distinction drawn between maintenance and growth capital expenditures, with the latter having a sort of optionality attached to it. However, most corporations do not divide the two types of capital expenditures in their reports, and even if they did, the companies have a vested interest in making the growth category as large as possible, both because it makes free cash flows look better and because investors like growth. And of course, it is a distinction without a difference in many cases, as the money is spent either way. Therefore, the wise approach is to take the conservative view that all capital spending is maintenance capital spending.

However, owing to the declines in Lodgenet’s sales and operating cash flows, we do not have this luxury of choice; it is clear that levels of capital spending are below replacement levels, as the lower than average capital expenditures for the last few years may indicate, as would the lowered amounts of actual hotel rooms serviced (1.8 million as of the first quarter 2011 as compared to 1.98 million in 2008). It may be that, like Mac-Gray, Lodgenet is shedding its lower-margin clients, and indeed Lodgenet is focusing on expanding its high-definition offerings, but that too may require more capital than current spending would indicate.

So, enough of dancing around the figures; let us examine them. In 2010 sales were $452 million and reported operating earnings were $23 million.  Depreciation was $83 million and capital expenditures were $22 million. This produces excess depreciation of $61 million, which makes operating cash flow $84 million. Interest expense that year was $34 million, leaving pretax cash flow of $50 million, or $32 million after estimated taxes. Taking out $5 million for preferred stock dividends leaves $27 million in estimated free cash flow to common shareholders.

In 2009, sales were $463 million and reported operating earnings were $22 million. Depreciation was $100 million and capital expenditures were $21 million. This produces excess depreciation was $79 million, which makes operating cash flow $91 million. Interest expense that year was $38 million, leaving $53 million in pretax cash flow, or $36 million after taxes. Taking out $6 million in preferred stock dividends (they did not actually incur this expense, but for purposes of calculating future earnings power we should take it into account), we have $30 million in estimated free cash flow to common shareholders.

In 2008, sales were $534 million and reported operating earnings, apart from a goodwill impairment charge, were $6 million. Depreciation was $124 million and capital expenditures were $64 million. This produces excess depreciation of $66 million, which makes operating  cash flow $66 million. Interest expense that year was $42 million, leaving $24 million in pretax cash flows, or $16 million after estimated taxes. After the preferred stock dividend, this leaves $10 million in after-tax free cash flows.

In 2007, sales were $486 million and reported operating earnings were $-4 million. Depreciation was $116 million and capital expenditures were $79 million (not including acquisitions made that year). This leaves excess depreciation of $43 million, producing operating cash flows of $39 million. Interest expense that year was $41 million. Of course, this was the company’s first year operating on such a large scale, and also the year in which they borrowed the money to pay for the acquisitions that is now causing the firm so much trouble.

As we see, much of the improvements in 2009 and 2010 in terms of free cash flow are owing to the lower capital expenditures in these years as compared to 2008 and 2007. In fact, if capital expenditures were at the five-year average levels from 2006-2010, which is $47 million, there would be hardly any free cash flow to shareholders, apart from the tax benefit of excess depreciation. It may be that Lodgenet’s business calls for a large initial investment and then lower maintenance expenditures, but considering the short lifespan of Lodgenet’s capital assets (the company took $75 million in depreciation charges in 2010 on $206 million in property and equipment from 2009’s closing balance sheet, producing a weighted average life of 2.75 years), I would not bet on it. Lodgenet has been using its free cash flow to common shareholders, including the tax benefit from the excess depreciation, more or less exclusively to pay down debt.

The company released its first quarter 2011 earnings last night (which is why this article wasn’t published two days ago). We can see more of the same trends at work; sales were $107 million, down from 118 million for first quarter 2010. Reported operating earnings were $6.9 million, depreciation was  $19.6 million and capital expenditures were $4.6 million, producing cash flow from operations of $21.9 million, as compared to $24.2 million for first quarter 2010. Interest charges were $7.7 million, as compared to $8.7 million for first quarter 2010, leaving $14.2 million in pretax cash flows, or $9.2 million afterwards. Taking out $1.4 million in preferred stock dividends leaves $7.8 million in free cash flow to common shareholders. The comparable figure for first quarter 2010 is $8.7 million. I am hesitant to draw too many conclusions from these results, particularly as capital expenditure levels can vary over the year and the firm spent only $4.6 million on capital expenditures while management suggested in its earnings call that capital expenditures for the full year of 2011 would be in the $25-30 million range–which itself is higher than in 2010 and 2009, further biting into free cash flow.

So, on top of the diminution in earnings, I find that we are once again confronting our paradox of valuation, that a company in the process of deleveraging can increase its value based on free cash flow  over a given period by less than the amount it actually earns in the same period. Here, it is clear that debt is a problem at Lodgenet, as shown by the two equitization moves and the necessity of renegotiating the debt. As of the company’s last report, its long-term debt stood at $360 million, with the firm able to devote an estimated $50 million per year towards paying it down ($29 million in free cash flows as estimated, plus $21 million in estimated tax benefits from excess depreciation). Lodgenet claims, and not without justification, that the amended credit agreement has bought the company some breathing room, but with cash flows on the decline and capital expenditures at below replacement levels anyway, it is not apparent to me that the debt issue is safe.

So, is Lodgenet ultimately a value investment? I should say no. The difficulty is that although I can see that capital expenditures are below maintenance levels, I do not therefore know what the correct level of capital expenditures would be, making it impossible for me to calculate free cash flow. As a result, I cannot estimate how many years it may be necessary for Lodgenet to devote substantially all of its free cash flow towards debt repayment (the new credit agreement requires 75% of excess cash flow to be directed to that purpose for the lifetime of the agreement), which renders the free cash flow multiple approach impossible (as funds required to be used to pay down debt are definitely not “free). Nor am I satisfied that the debt of Lodgenet, even with the new credit agreement, is safe from default, or more likely, from having to make further concessions in a renegotiation.

Therefore, despite the apparently attractive free cash flow yields of this company, there are far too many unknowns present for me to be able to say that there exists a definite margin of safety or a low probability of ultimately losing money, and I would advise passing on Lodgenet at present. Even though purchasers of this company can (and most likely will, now that I’ve spoken against it) reap  great rewards from this firm, I do not feel there is anywhere close to enough assurance of the same.

I have often found compelling values in rural telephone companies, such as Windstream and Qwest (now acquired by CenturyLink, as they throw off large amounts of free cash flows and are kind enough to produce dividends. My latest discovery in this area is Consolidated Communications (CNSL), which pays 8.4% and which has a free cash flow yield of 11.4% after excess cash is taken into account, based on last year’s results. Unlike Windstream and Qwest, Consolidated uses wireless partnerships to offset loss of traditional customers, as well as high speed Internet, which adds a further level of stability.

I have also reexamined my views of excess depreciation and amortization: Although it is wise to run the calculations first treating the excess depreciation as taxable, and to place significant weight on that calculation, it may be helpful as well to make a reasonable, conservative projection of the actual present value of the tax benefits associated with excess depreciation. Of course, as with all projections, this one is unlikely to be ultimately accurate and one should avoid using only this measure to justify an investment, but the projection must still be of interest to investors.

For my full views on Consolidated Communications, please visit http://seekingalpha.com/article/264006-consolidated-communications-a-strong-candidate-for-dividend-investors

Since my last foray into the paper industry with Boise Inc., I thought it would be appropriate to review the rest of the sector. After some searching, I have settled on Domtar (UFS).  Domtar is the largest producer of uncoated freesheet paper in North America, and also a producer of wood pulp, with operations in several locations in the United States and Canada. The company was formed in 2006 to purchase Weyerhaeuser’s fine papers division, which transaction was consummated in May of 2007. Obviously, the timing of the deal was not the best, as the firm has had to recognize significant goodwill and asset impairments since that event. However, these impairments are noncash expenses, and Domtar has produced an attractive record of free cash flows since the acquisition, with free cash flow yields of above 11% even during the difficult 2008-2009 period. Also, the company has on its balance sheet over $500 million in excess cash, out of a market cap of $3.85 billion.

Furthermore, Domtar has not shied away, as many acquirers do, from the usually necessary process of whittling down of unneeded or underperforming assets following an acquisition. In fact they have shut down several underperforming paper mills in Mississippi, in Saskatchewan, Ontario, and Quebec, and in California. The company has also repurposed its plant in North Carolina to produce purely fluff pulp in response to market demand. Finally, the firm has sold off its wood and lumber products business since the acquisition. In fact, as recently as last week Domtar announced the closing down of a papermaking line at its plant in Arkansas.

As a result, the company has been able to maintain a high level of free cash flows throughout the 2008-2009 period despite a lowering of demand, and 2010 was a dramatically impressive year for Domtar, with free cash flows of $583 million, equal to almost 1/6 of the firm’s entire market cap. However, this may be the result of a fortunate confluence of circumstances, where sales prices increased without the cost of inputs catching up and therefore the 2010 results are perhaps atypical. Domtar has recently been using its impressive free cash flow to pay down its debts, having paid back $917 million in 2010 and $400 million in 2009.

Turning to the figures, I would first like to address the excess cash level. A common measure of a firm’s excess cash is the total cash and investment on the books, minus the extent to which current liabilities exceed current noncash assets. (Of course, cash being described as “excess” does not mean that a company could instantly declare a special dividend of all of its excess cash without its liquidity suffering; it merely means that a purchaser of a company’s stock is allocating part of his or her purchase price to cash that is not encumbered by any pressing need. Therefore, the purchaser may be said to “claw back” that amount from the purchase price, while the remainder is allocated to the actual capital assets of the business. A business that is strongly cash flow positive (and as a value investor, those are the only kinds of business I like investing in) may be expected to produce the cash to address its noncurrent liabilities out of its future earnings, and the extent to which the company’s prospects indicate that they can do it governs whether the excess cash as calculated is really excess, which in Domtar’s case I believe it is. This analysis also requires a determination that a company’s debts are manageable, which again is true in Domtar’s case; interest is covered over four times in each of the last four years surveyed).

For Domtar, based on its latest balance sheet, the firm has $530 million in cash and $1.47 billion in noncash current assets (of which $1.25 billion consist of receivables and inventories, rather than the more nebulous categories of “deferred taxes” and “other”), set against $725 million in current liabilities. As a result, noncash current assets exceed noncash liabilities and therefore all $530   million in cash may be considered excess. Taking $530 million off of the market cap of $3.85 billion leaves $3.32 billion representing the market value of Domtar’s capital assets.

In terms of earnings, in 2010, Domtar’s sales were $5.85 billion and operating earnings as reported came to $603 million. However, because of noncash impairments resulting from plant closures, and other closure- and restructuring-related costs, $77 million in expenses should be considered noncash and/or nonrecurring. This produces $680 million in income from operations, which, after interest expenses of $97 million, leaves $583 million in pretax earnings, or $379 million applying a 35% tax. (In fact, Domtar reaped a tax windfall in 2010 and 2009 for operating loss carryforwards and a tax credit for black liquor, a byproduct of producing paper pulp that makes an excellent fuel and which qualified for an alternative fuel subsidy from the US government in 2009. However, the subsidy has expired, and for purposes of forecasting Domtar’s earnings power, it would be preferrable to apply the statutory, rather than the historical, tax rate).

Furthermore, as with many companies, Domtar has an additional source of free cash flow in that its depreciation charges of $395 million have exceeded its capital expenditures of $153 million. This leaves $242 million of additional cash flow to Domtar’s owners, producing total free cash flows to equity of $583 million. This represents a free cash flow yield of 17.6% based on the $3.32 billion market value of Domtar’s operating assets. This source of free cash flow is presently untaxed, although eventually the gap between depreciation and capital expenditures may be expected to resolve itself at which point this will no longer be the case. However, Domtar is still in the process of whittling away at its underperforming assets to increase its competitiveness and therefore the current levels of capital expenditures may be considered reasonable for longer-term estimates. Therefore, at the current rate of capital expenditures the gap will take many years to close, during which time the excess depreciation will continue to be tax-free.

For 2009, sales were $5.47 billion and reported operating earnings were $615 million. However, this was the year of the black liquor tax credit, which contributed $497 million in nonrecurring extra income, which was offset by $125 million in impairment and restructuring charges. Therefore, actual operating earnings were $243 million, before interest expenses of $121, leaving $122 million in pretax earnings, or $79 million after taxes. Excess depreciation that year came to $299 million, producing free cash flow of $378 million.

For 2008, sales were $6.39 billion and reported operating earnings were $-437 million, but this year included noncash and/or nonrecurring impairments and restructuring charges of $751 million, producing actual operating earnings of $314 million, before interest expenses of $132 million, leaving $182 million in pretax earnings, or $118 million after taxes. Excess depreciation in that year was $300 million, producing free cash flow of $418 million.

Domtar’s acquisition of Weyerhaeuser’s fine papers division occurred in May of 2007, but the firm was kind enough to include pro forma earnings in its 2008 10-K. For 2007, sales were $5.95 million, reported operating earnings were $270 million, before $31 million in noncash or nonrecurring events, producing actual operating earnings of $301 million. Interest expense that year was $142 million, leaving $159 million in pretax earnings, or $103 million after earnings. Excess depreciation that year came to $355 million, producing $458 million in free cash flow.

In 2006, Domtar’s business was still inside Weyerhaeuser, and curiously the financial reports do not allocate any interest expense to it. At any rate, sales were $3.31 billion and reported operating earnings were $-556 million, before noncash or nonrecurring impairments and other items of $701 million, leaving $145 million in actual operating earnings, or $94 million after taxes. Excess depreciation came to $247 million, producing $341 million in free cash flow.

So, what can we take away from these figures? The paper industry is a cyclical industry, and, according to Damodaran in his useful toolkit, The Dark Side of Valuation, it would be unwise to base our valuation on the most recent year even if it was not an unusually good one, but to look at the performance over a broad cycle. Unfortunately our data do not cover an entire business cycle. However, I would say that 2010 was a very good year, with sales increasing 7% and cost of sales actually declining 1%, according to the firm’s 10-K, a situation that may not continue through 2011 and thereafter in an environment of rising costs. By contrast, 2009 was no doubt a period of unusually weak demand owing to the financial crisis and its aftermath (although in 2009 the firm still produced $378 million in free cash flow, which, when set against the $3.32 billion price the market is setting on Domtar’s capital assets, is still a free cash flow yield of 11.4%).

If I had to pick a single figure for Domtar’s earnings power, I would say that it lies between those two extremes. At any rate, if we average the 2007-2010 free cash flows we get $459 million per year, which, set against the $3.32 billion market cap after removing excess cash, produces a yield of 13.8%, which I find very attractive.

I conclude, then, that Domtar has strong earnings power and as long as its management can continue to adjust to changing economic conditions by adapting its productive capacity, it should continue to produce high levels of free cash flows for its owners. As such, I can recommend as a portfolio candidate.

Dell, although not a company that fires the imagination, has a market cap of 28 billion, of which 12.5 billion consists of cash and investments that the company does not seem to particularly need. Dell’s free cash flow, not counting investment income, came to 2.86 billion last year, representing a yield of 18.5%. Dell will be increasing capital expenditures next year, which may cause the free cash flow yield to decline to the 2.5 or 2.6 billion area, in order to continue their strategy of modest growth. I wouldn’t rely on growth, but I’ll definitely take the amazing yield.

For my full analysis, see

http://seekingalpha.com/article/259200-dell-boring-company-exciting-numbers

Several of my readers have written me requesting my opinion on the recent downgrade of the River Rock Entertainment Authority casino bonds that fall due November of this year. The effect of this downgrade has pushed the price of the bonds from the 94 range to the 88 range based on recent prices.

I found the text of Moody’s downgrade announcement, and it stated that the grounds for the downgrade were the lack of significant progress on refinancing and the casino’s other financial obligations such as the emergency access road they are required by their agreement with Sonoma County to construct. Taking the second one first, it is true that River Rock agreed to build the road in 2008 (and to complete construction by 2009, but you know how things are with construction), and that they have escrowed $4.3 million in cash out of their total cash holdings of $43.6 million for the purpose of completing it. I hope that the delay in construction has not imperiled the casino’s relations with Sonoma County, but if the estimate of remaining construction costs is close to accurate, the casino should be able to absorb the cost without difficulty, as according to my previous estimates the casino generates roughly $30 million per year of free cash flow, of which only $11 million is officially distributed to the Tribe.

The refinancing issue is perhaps more troublesome, and Moody’s announcement that there has been a lack of progress is frightening for the markets in that it is ambiguous. A “lack of progress” could mean simply that the River Rock Entertainment Authority has not been active in contacting investment banks to get the refinancing done, in which case they may want to get moving. I don’t know how long it takes to analyze, issue, and sell a bond issue of this size, but I suppose that as the deadline is known and the refinancing is important to River Rock, that it is not too early to expect forward movement.

The more sinister interpretation is that River Rock has been shopping the deal around and had difficulty drawing the interest of investment banks, which could mean that the casino might be forced into higher interest rates or more restrictive covenants. If this is the case, I would attribute it more to the perception of the weakness of the gaming industry as a whole than anything specific to River Rock; as I calculated in my initial recommendation of the bonds, free cash flow covers current interest expenses by roughly three times, which I consider reasonably safe.

Although it is true that there is a competing casino proposed 30 miles south of the casino along the same route that gamblers from the Bay Area would take to get to the River Rock casino, that new competitor is is still in the planning and permitting stage and there are months or years of legal wrangling involved (including the fact that the proposed new site encroaches on the habitat of an endangered newt) before construction can even begin, and at any rate the new casino might not siphon off as many customers as investors fear. Furthermore, River Rock generates significant cash flow in excess of tribal distributions, one solution might be that the new bonds could be given an amortization provision so that the load of interest and principal requirements are cut to what the market would perceive as a more manageable level by the time the new casino is expected to begin operation.

Another issue I have with the Moody’s report is that it apparently assumes that the loss from default will be 50%. I consider this estimate to be completely baseless: not only do the casino’s current cash flows appear adequate to its current interest requirements forever, but they also have no basis from which to calculate the extent of the loss. No Indian casino has ever tested the bankruptcy process, and because only an Indian tribe can hold an interest in a casino, the usual result of a bankruptcy where a class of creditors becomes the new equity holders is unavailable, thus injecting an unwanted level of uncertainty into the situation. As a result, I think a default would be somewhat less painful for the bondholders, particularly as River Rock has recently been building up cash on its balance sheet perhaps in anticipation of being able to float a smaller bond issue.

I should also point out that Moody’s may be drawing upon information has not been made public yet; River Rock’s last 10-Q appeared in the middle of November 2010, and they did not release their annual report until March 31 last year, so it could be that the market is simply overreacting in the absence of updated information. When the annual report is finally released this year, I will read it with interest and it might move me to be more concerned. But as things stand, the downgrade itself does not strike me as particularly significant.