Butler National Corp (BUKS) is a micro-cap company ($25M market cap) operating two very different businesses: Aerospace / Avionics and Casino Gaming Management. Both businesses generate healthy cashflows and shares are currently trading less than 6x next years earnings. Furthermore, we believe current share prices offer investors a chance to buy the Aerospace business for 10x 2019 earnings while getting the casino business for free.

There is, however, a tremendous amount of hair to stomach. Higher-than-average management compensation, failure to sell-off the casino business, a special counsel insisting dilution and a stagnant share price are all tangible reasons to be worried. Despite these issues, we believe the price is cheap enough to tolerate the risks. Downside protection is found in healthy company backlogs, the highly profitable operating segments, a stellar balance sheet and possible sale of the casino. With management owning over 20% of the company, incentives are aligned.

What They Do

The Aerospace segment (operating over 50 years) provides systems integrations, engineering, manufacturing, installation, service and repair of aircraft & aircraft related products. It’s broken down between Aircraft Modification (i.e., a customer wants customized sensors, cameras, etc. put on their LearJet) and Avionics (which deals more with Defense Contracting/Electronics). They serve 34 international markets. An example of their service is modifying a Learjet engine “muffler” to reduce noise — making it compliant with STC / FAA permits. They also do testing and controls of various apache helicopter guns.

Butler’s Casino Gaming Management segment operates the lottery gaming facility Boot Hill Casino & Resort (which started in 2009). BUKS manages the casino and has recently sunk over $1M to renovate the building, put in new slots, update rooms/carpets, etc. The business produces cash, however, bringing in over $30M in revenues on a TTM basis (after accounting for 80/20 split with state of KS), and $11M in gross profit (37% GM). They’ve operated in the casino space since the 1990s.

High Barriers To Entry in Both Businesses

Niche aerospace businesses aren’t easy businesses to start. Not anyone can roll LearJets into their garages and hack away. Before an airplane can begin modifications it is required to contract a company that is approved by the FAA, the STC or in some cases both. Secondly, I believe switching costs are high amongst BUKS’ customers. Once you find your airplane modification company — and you know their work — you wouldn’t shop around for the lowest price. This makes sense intuitively as BUKS works primarily on private jets meeting compliance standards. Another barrier to entry is the quality of workers — which BUKS can’t seem to hire enough of. These aren’t your standard “aircraft engineer” hires. In order to operate as a modifications company, you need to hire those that are willing to think creatively to solve specific customer problems. Management addressed this very topic in their latest earnings call, saying:

“It’s not your typical airplane worker or your typical sheet metal mechanic or your typical anything in the aviation industry. It’s a unique group and when we start varying outside of that, we run into all kinds of problems.”

High barriers to entry are also present in BUKS’ casino operations. Kansas is one of the stricter states when it comes to gambling/casino laws. In fact, with the passage of the Lottery Act, the state only approved for four casinos to be built — one in each region. Because of this, BUKS’ casino benefits from local monopoly effects. The region they serve covers roughly 200K people. This isn’t a lot of volume, per say, but what else is there to do in Dodge City, KS on a Friday night when it’s not Jay-hawk basketball season?

Is The Business Cheap?

As a whole, the company’s generated a little over $5M in operating income for TTM 2019 on $57M in revenues. Given current market cap of $25M, you can buy shares for 5x earnings. Looking at it another way, we can think of what we would pay for the aerospace business — which is the business I think offers greater potential. On a TTM basis, the company generated nearly $25M in revenues from Aerospace and over $2M in operating earnings. So, in essence you’re paying ~10x earnings for their aerospace business while getting the casino management business (IMO the more stable business) for free. On top of that, current share prices present a 17% discount to book value and an EV/Sales of 0.43.

As a further measure of downside protection (aside from the cheap price and discount to book), BUKS has the healthiest backlog they’ve ever had as a company (coming in a little above $16M as of last earnings call). That’s almost their entire market cap in revenues on the books. If we assume historical operating income margins of 10%, the $16M in revenues should add roughly $1.6M in operating earnings. They also sport $8M in cash against $2M in long-term liabilities (with very minimal debt).

Why Is It Cheap (The Hair)?

Like I mentioned earlier, the company has issues:

– Issues with Spinning-off / Selling Casino Business.

– Bizarre “Review Board” suggesting the company issue 12.5M more shares outstanding (will touch on later).

– Inability to hire enough people.

Failure to Find a Seller

Management’s been trying to spin-off / sell the casino business for over a year without progress. In their last earnings call, Clark Stewart (President & CEO) said:

“The answer is yes, we have [thought about spinning off casino]. And the answer is we have plans to spin that thing out and give it to the shareholders, separate from — or from the Aerospace side. We haven’t got to that point because we need to have these…”

Shareholders want the casino business gone so that the extra capital can be plowed back into the aerospace business. One analyst echoed this sentiment on the call, saying, “Spinning it out is fine, but you still have to have somebody operating it. You still have to — I’m sure it would still, in some respects, you’d have a minority interest in the Butler National umbrella. I’m just talking about selling the darn thing. Selling it, bringing in the cash and reinvest and investing that cash in the growth area of the business and getting rid of all the headaches.”

If they were to get rid of the casino, a sale would be better than spinning it off. A company this small would have a hard time absorbing the cost of spinning off the casinos, making it a public entity and listing it on an exchange.

Special Council Suggesting Dilution

Finally, the company hired a study group that said BUKS shouldn’t, “have more than 20% share overhang.” In other words, the study group thinks the company should issue around 3% of 12.5M shares of stock. This is in relation to incentive structure where the study group estimates they should be diluting more shares as compensation (or some form of that, via options, etc.). Clark explained it in the earnings call, saying:

“Unless we can buy back more, we’ve been trying to buy them back, but we haven’t. We haven’t done that. We — the group says we should issue the incentives, we’re not — we have not issued any in the last 3 years or 4 years, longer than that, but study was really 3 or 4 years’ worth, and they said that we haven’t done anything, you need to be doing some. So that’s how we got to $12.5 million. We said “Well, we’ll get that approved.” Now they’re coming back to us, said, “Well you ought to issue them. You haven’t done anything.” And so that was the upgrade for the study group. But that’s where that is. Yes, that will increase the number of shares outstanding until we get them bought back up. That’s it…”

In other words, looks like the plan is to issue 3M shares outstanding over the next year or two, with management’s intention on buying those shares back to reduce the dilution effect. This dilution suggestion seems strange, and large shareholders (obviously) aren’t thrilled about the idea of being diluted.

Potential Catalysts: Activist/Insider Purchasing & Spin-off/Sale of Casino

Clark Stewart’s been buying shares hand-over-fist on the open market recently (see here for the Form 4 filings). He owns close to 7% of all shares outstanding. There is 0 institutional ownership. In total, management owns close to 20% of the company. Another major shareholder is Joseph Patrick Daly, who owns 10% of the company. Daly is joined by another outside investor, Zeff Capital, which owns over 6% of the common. Together these outside investors make up over 16% ownership.

If the company is able to sell the casino business, it would have the capital needed to plow into the aerospace business to hire more people, take on more orders and churn through backlog at faster rates. I think that segment can grow top-line revenues at double-digits given their niche in the industry, the technicality of the work they do, and the barriers to entry within the space.

Valuation: Painting Two Pictures

The company generated $3M in FCF (14% FCF yield) in 2018 with double digit EBITDA margins. If we assume no growth over the next five years, historical margins and average capital expenditures (around 5% of revenues), the company should be worth around $32.5M, or ~$0.56/share.

What kind of multiple do we assume for a high barriers to entry, niche aerospace with a healthy casino business company? 7x, 10x, 15x? I don’t know, and it’s hard to find comps for a company that specializes in such random segments. However, if we assume a 10x multiple on those earnings (which we’re assuming aren’t growing), we end up with an EV of $38.5M, or a little over $0.60/share.

Now, if we assume BUKS is able to grow top-line revenues at a modest 5% annually over the next five years — an achievement that isn’t unlikely given the health of their aerospace backlog — what does valuation look like? By 2023, the company would generate nearly $7M in EBITDA, over $4M in FCF and be worth roughly $39M (or $0.66/share).

Potential Scenario: Sale of Casino?

This is where things gets interesting … and it requires a bit of guesswork on our end, which we’re okay with. We might not be right in our assumptions, but it gives us a ballpark in which to pitch probabilities. Let’s assume the casino sells for 1x revenues, or $23M. How would this affect the income statement and balance sheet? Selling the casino turns BUKS into a pure-play niche aerospace modifications company with nearly $20M in revenues, 37% gross margins and close to $3M in operating earnings.

The balance sheet becomes even more bullet-proof. The sale would add another $23M in cash to the books, bringing the total to $31M. Tangible assets (less the casino) would hover around $10M ($6M from aircrafts and $4M from machinery / equipment). Even if we anticipate that the aerospace business assumes 75% of all liabilities, we’re left with $0 in EV. In other words, we’d be receiving the high margin, high barrier to entry and highly profitable aerospace business for nothing.