Wednesday, 19 July 2017

Time to take a punt on Nagacorp?

Nagacorp (3918 HK) is a company I have followed for a while. The company owns a first-class asset - an exclusive monopoly license to operate a hotel-casino in Cambodia's capital city Phnom Phen out until 2035 (which is built out and operational). The company has been growing like a weed, benefitting from growing tourism flows into Cambodia, and rising regional and (in particular) Chinese wealth (a key source of inbound tourism and gaming dollars).

The company took the significant downturn in Chinese VIP gambling activity in 2015-16 in its stride (which followed a Chinese corruption crack-down which hit Macau pretty hard), with the downturn barely registering in Nagacorp's financials. This reflected the property's mass-market appeal (about 50% of gross profit), coupled with its VIP positioning as something of a 'poor man's Macau' (although it has also been speculated that company has benefitted from Cambodia's somewhat more 'off the radar' location and lax oversight). The casino also benefits from gambling tourism from Vietnam, where until recently gambling was outlawed (a modest relaxation of these restrictions is currently being discussed/trialled).

Piquing my continuing interest over the years has also been the fact that the stock has long been cheap, sporting a (prima facie) high single digit PE; mid-high single digit dividend yield, and a net cash balance sheet. On the surface, it has long seemed like a good story and an obvious buy. But alas, a little digging revealed the story to be far more complex than that.

Digging a bit deeper

Unfortunately, the market seldom hands out obvious gifts, or at least does not do so without a reason (it may not be a good reason, but there will always be a reason, and you should know what it is before you invest). It looked and instinctively felt a bit too good to be true.

Some discount was warranted for the political risk of operating in Cambodia - particularly because the tax rates the company was paying were very low, and potentially too low to be politically palatable long term (indeed, the company was required to pay US$16m in additional taxes last year, and recent news suggests this extra-contractual 'levy' is being repeated this year as well). In addition, the legalization of gambling in Vietnam was a risk (although the company's custom has since diversified more towards Chinese tourist flows). Nevertheless, the valuation appeared anomalously low, and the share price had been falling for 5yrs despite strong operating performance.

I smelled a rat when I saw that the company had done several placements of new shares to institutional holders in recent years. Why would the founder and major shareholder be willing to diluted his interest at such a cheap share price, when the company was already net cash and highly cash generative? (the capital needs of the company's Vladivostok expansion project were insufficiently large and pressing to necessitate these capital raisings).

A careful dig through the company's past filings revealed why. Several years ago (2011 if memory serves), the company decided to undergo a significant capacity expansion at its Cambodian premises, via the construction of 'Naga2', adjoined to the existing premises by an also to-be-constructed 'NagaWalk', that would feature high end retail space (which China Duty Free has since leased).

However, instead of either funding this expansion from operating cash flow/borrowing, or conducting a typical share placement/rights issue, the company entered into an unusual related-party financing scheme with its major shareholder - namely an agreement to issue US$369m in convertible bonds at a future date with a conversion price equivalent to Nagacorp's share price at the time the deal was first signed of HK$1.82. The major shareholder agreed to finance the development of the Naga2 and NagaWalk properties himself, and once the assets were completed and transferred into Nagacorp, the convertible bonds would be issued (US$275m worth for Naga2, and US$94m for NagaWalk), and both would be convertible to ordinary shares at HK$1.82.

While the above transactions were unusual, if that was all there was to it there wouldn't be a significant amount to be concerned about (or at least enough to be concerned about for this to be a complete deal-breaker). True - it would grant the major shareholder the ability to effectively take shares in a placement at the then share-price of HK$1.82 without incurring any upfront cash cost (with the cash instead deployed gradually over the construction period of some 5yrs), but the major shareholder would also be underwriting the risk of any capex overruns, and the construction cost estimates did not seem excessively high (although this is difficult to confirm, and at best it likely resulted in the privatization of a sizable construction development margin). On the flip side, he would forgo ordinary share dividends during this time, which have been quite generous. All told, a modest chiseling of minorities perhaps, but not a complete deal-breaker.

However, the real problem came from the manner in which the company and the putatively independent directors interpreted a conversion-price-adjustment provision in the convertible bond document. Instead of the conversion price being adjusted merely for stock splits, stock bonus issues, and discounted rights issues, which is the correct and conventional approach, the adjustment provision was interpreted as being capable of invocation for any change in the nominal share capital - even those arising from a regular share placement.

This had the practical effect of lowering the conversion price every time a share placement was conducted (e.g. if a new placement of say 7% of the previous shares outstanding was conducted, the convertible bond conversion price would be adjusted down by comparable 7%; this effectively resulted in the major shareholder being issued additional shares for free on a 1:1 basis with new shares placed in a capital raising, resulting in double the minority dilution).

It also (1) created an incentive for the major shareholder to do additional unneeded share placements (who doesn't want free shares?); and (2) also created an incentive to incur additional capex for additional expansion projects in order to justify additional placements, whether such projects were economic in their own right or not. Suddenly it was obvious both why such share placements had previously occurred, and why the stock price was as low as it was.*

Indeed, a number of share placement during 2011-16 had already resulted in the conversion price of the convertible bonds being steadily 'adjusted' down to just HK$1.53, resulting in the convertible bonds being entitled to be converted into hundreds of millions of additional shares. Furthermore, once the convertible bonds were issued (after the assets were completed and injected into the Nagacorp entity, which has happened recently), they were entitled to receive dividends as if they had been exercised, but had no mandatory conversion date! This mean that the major shareholder was unlikely to ever exercise them (why do so - you are already getting the dividends) and continue to enjoy a free kick via a reduced conversion price every time a future capital raising activity was undertaken (which, due to this distorted incentive, would likely occur semi-regularly). This meant the degree of future shareholder dilution was uncapped and potentially significant.

Intriguingly, a provision in the original convertible bond circular betrays the fact that this heavy minority dilution was contemplated at the time of issuance, as there is a provision stating (in one of the few restrictions imposed on the conversion terms) that the conversion terms could not allow the major shareholder to end up accumulating enough shares that it would result in the company failing to meet the minimum free-float requirements imposed by the HKSE. This would only be threatened if the conversion price was adjusted down so significantly over time that the number of shares issued diluted minority shareholders much more significantly than most investors understood would be the case at the time of the convertible bond agreement.

Cognizance of the above was a deal-breaker. As I was proceeding through my original research process, I had accumulated a small position (I find having a small amount of money on the line sharpens one's focus), but immediately sold once the above all became clear (for a small profit, as luck would have it). Without any potential limit on future dilution, valuing the shares was nigh on impossible (it is important to never forget that the value of a share in the hands of a minority shareholder is not necessarily the same as the value of the shares in the hands of a controlling shareholder and/or the value of the operating assets themselves).

I had unfortunately uncovered what appeared to be one of the more egregious instances of minority shareholder abuse I had seen, carried out in broad daylight. I was surprised there had been so little broker/media/activist discussion (true to form, most brokers blithely ignored the issue while also generally failing to properly dilute for the coverts in their multiple-driven price targets). I was annoyed, at the time, that I had wasted a couple of days of research time on the stock with so little to show for it.

However, one of the great things about building up knowledge and experience as an investor is that you never quite know when such knowledge may come in handy again down the road. And as fate would have it, this past research may yet prove useful (the advantage of a knowledge bank is also that it allows you to act swiftly when circumstances change, as you are able to diagnose the significance of new events both more quickly and more accurately than newcomers to the stock).

Recent over-reaching could be a catalyst for reduced future dilution risk

The above ruse has been going on for a while, but the major shareholder recently looks to have overreached and pushed the envelope a bit too far. As previously noted, the convertible bonds were issued in two separate tranches (one for Naga2 and one for NagaWalk), and the major shareholder recently proposed to convert one but not both of the tranches into ordinary shares. This would then trigger the price adjustment mechanism in the other convertible tranche, resulting in the conversion price being adjusted down to just HK$0.65 in the second tranche. The outcome would be the issuance of an additional 600m odd shares to the controlling shareholder (representing about 14% of the previous fully-diluted share count).

The prior adjustments to the conversion price seem to have gone unnoticed by many institutional holders (many of whom, I might add, manage significantly more money than I, and have significantly more operational resources), but this final adjustment was so egregious that it has finally been noticed by all. It resulted in an immediate cratering in Nagacorp's share price from HK$4.20 to HK$3.30, and has also prompted a minority shareholder revolt, including from hedge fund Nine Masts Capital (who owns 0.9% of Nagacorp), which is challenging the agreement (reported by Bloomberg).

The extent of the share price plunge, coupled with numerous investor protestations and increased media scrutiny (Nine Masts sent an open letter to the board that was circulated to the media), appears to have prompted some hasty and much-needed backpedaling. More specifically, it has resulted in a revised proposal that will result in the major shareholder instead exercising the two series of the convertible bonds concurrently (subject to a whitewash waver from the HKSE to avoid the need for a change of control minority take-out offer, as well as minority shareholder approval), and also exercising them immediately after the above approvals are secured.

If this concurrent conversion happens, it will be a material positive for three reasons: (1) it will reverse the pre-existing 600m shares of extra dilution; (2) just as importantly, it will result in the convertible bonds being exercised in their entirety rather than remaining unexercised, which will remove additional dilution from future capital raisings (and the incentive to undertake them); and (3) the revised proposal also demonstrates that the board and major shareholder have some sensitivity to media and shareholder scrutiny (in theory at least, they could have chosen to simply ignore Nine Masts letter and associated adverse publicity, although legal action may also have been threatened).

The news prompted an immediate rebound in Nagacorp's share price to HK$4.20, reversing the previously priced-in impact of #1. However, the impact of #2-3 are yet to be price in in my view (the stock has since run up to HK$4.70, but that appears to have been triggered primarily by a very strong 1H17 result). In addition, it is possible that Nine Masts Capital and/or other holders will, as part of this process, challenge the prior conversion price adjustment from HK$1.82 to HK$1.53 as well (Bloomberg has reported that Nine Masts is attempting to do just that). If they succeed with this challenge, that will be a material further positive.

The stock remains inexpensive, at about 10x diluted earnings (PE) with a high-single-digit percentage of the company's market cap in cash, and with a doubling in capacity following the Naga2 commissioning coming on stream from 4Q17. Inexpensive that is, on the very important proviso that we have now seen the end of material minority shareholder abuse.

Time to take a punt?

A bear case from here is simple enough - if the major shareholder wants to screw you, he will most probably find a way to do so, and so you'd be a fool to bet against it, and the independent directors have shown themselves to have been far from genuinely independent to date. There is therefore an sufficiently high risk of future convertible bond issues and/or other 'creative' related-party transactions, which would hammer the share price, to steer well clear.

The bull case would be that, in addition to the obvious point that the stock is very cheap, that the the backlash and additional media scrutiny we have recently seen is likely to reduce the inclination of the company to attempt similar such transactions in the future. In addition, the major shareholder now already enjoys a large shareholding of 60-65%, and HKSE regulations require a minimum free-float of 25%, limiting the capacity of the major shareholder to dilute minorities materially further (at least if the company wishes to remain listed - an attempted full takeout at a discounted price remains a significant risk). The major shareholder has also simply been a clever (although unethical) opportunist, and it is notable that the company has continued to pay out sizable dividends over its listed history, so minorities have not been fleeced wholesale. Recent minority shareholder protests have also not been ignored, as they could have been.

Time will tell, but the stock remains a punt because of the uncertainty created by the above. It is nevertheless a punt I have been prepared to take, and have recently initiated a small position at HK$4.70, because (1) I think the operating assets are easily worth HK$10/share or more, so a significant corporate governance discount continues to exist; and (2) because I do not believe the share price has yet reacted sufficiently enough to recent developments, which I believe have significantly reduced the degree of future dilution risk (i.e. the extent of the corporate governance discount has not shrunk enough compared to the prevalent situation last month). However, the position remains small and low conviction given the corporate governance risks involved.


*Interestingly, the effect of the convertibles did not show up in diluted EPS until recently, because it was merely an agreement to issue convertible bonds with a set conversion price in consideration for the Naga2 and NagaWalk assets at a future date (i.e. the convertibles were not yet issued - merely obligated to be subsequently issued); this is a loophole in accounting standards to say the least.

The above analysis is furnished for informational/entertainment purposes only, and is not to be construed as investment advice. The author provides no warranty whatsoever as to the accuracy of the contents of the post, and reserves all rights to trade in any securities mentioned in any article at any time.