Kinbasha Gaming International's Extreme Leverage is Both Risk and Opportunity - KNBA
|Oct 15, 2013|
I've run across a company with an unusual amount of potential. Before anyone gets too excited, I mean as much potential for disaster as potential for extraordinary returns.
Kinbasha Gaming International is incorporated in Florida, but operates exclusively in Japan. The US company was formed via reverse merger when a public shell company merged with Kinbasha Co. Ltd., a Japanese company in operation since 1954. Following the reverse merger with the public shell, Kinbasha CEO Masatoshi Takahama owns 62.6% of shares outstanding.
Kinbasha operates 21 pachinko parlors in Japan, 18 in Ibaraki Prefecture northeast of Tokyo, two in metro Tokyo and one in Chiba Prefecture. I must admit I was not familiar with pachinko prior to researching this company, but pachinko is apparently a very popular pastime in Japan. Think of a pachinko machine as a mix between a slot machine and a pinball machine, housed in an arcade with hundreds of others. According to the company, Japan has over 12,000 pachinko parlors, which attracted 12.6 million players and $227 billion in total wagers in 2011.
Players launch small steel pachinko balls and attempt to trap them, earning additional balls and points as they go. Much like pinball machines, pachinko machines are often themed, incorporating popular entertainment series and characters. Players trade the points they earn for items like candy and cigarettes on the premises, or can trade special vouchers awarded for high scores for cash off-site. Wikipedia has a much more thorough explanation.
Kinbasha's pachinko parlors are successful and produce healthy operating profit, but the company has a serious problem: its balance sheet. As of June 30, Kinbasha had $122.48 million in total capital leases, notes payable, bonds payable and accrued interest against shareholders' equity of negative $28.08 million. Worse, $92 million of this figure is in default. This massive debt relates to an expansionary effort the company undertook in the early 2000s, during which it attempted to build and operate restaurants and hotels. The expansion was a failure, and Kinbasha began to default on its debt in 2006. The company notes that its lenders could choose to foreclose at any time, which would result in the loss of its pachinko license and a wholesale liquidation, a scenario in which shareholders would likely receive absolutely nothing.
So here we have a company swimming in debt, with the specter of foreclosure and liquidation looming. Who in his right mind would invest in this? While the situation seems dire, things are actually not as bad as they look, for a few reasons.
1. This is Japan, where debt works differently. The Japanese government's number one fear is deflation, because of the disastrous effect it can have on a highly-indebted, demographically stagnant society. In order to reduce the chances of deflation, the Japanese government leans heavily on banks and lenders, encouraging them to restructure and extend defaulted loans, rather than foreclose. This "extend and pretend" strategy has drawbacks of its own, but it benefits Kinbasha. Though some of its debt has been in default since 2006, lenders have made no effort to begin foreclosure proceedings, and have actually forgiven some debt in restructuring deals. The company notes that its defaulted debt is subject to penalty interest rates of 14% and up, but few lenders have opted to charge the penalty rates, allowing the average rate on the defaulted notes to remain a very manageable 3.60%.
2. The company's operating profits are sufficient to cover interest expense and to make regular principal payments on its debt. Kinbasha produced $37.1 million in operating cash flow in fiscal 2013. The company used its cash flow to reduce debt and capital leases by $9.61 million in fiscal 2013, and by another $3.91 in the first quarter of fiscal 2014. Because Kinbasha generates this kind of cash flow, the company is worth more alive than it is dead. Lenders are not stupid, and they know that receiving full principal value over several years (with regular interest along the way) is better than shutting down the show and getting a fraction of principal in a liquidation.
As I mentioned in point 2, Kinbasha's pachinko operations generate substantial operating profit. Adjusted for a one-time gain in fiscal 2013, the company's EBIT was $11.69 million in fiscal 2013 and $13.75 million for the twelve trailing months. Fiscal 2013's results were affected by the the Fukushima earthquake, so I view the twelve trailing months figure as more indicative of sustainable EBIT. Interest costs for the most recent quarter were $1.71 million, which annualizes to $6.82 million. Kinbasha has net operating loss carryforwards of around $13 million, which will buy it a few more tax free years. Subtracting annualized interest expense from trailing EBIT gives pro forma net income of $6.91 million.
Going with that $6.91 pro forma net income figure, let's take a look at Kinbasha's valuation. The company has 12.26 million shares outstanding, and a bid/ask midpoint of $0.825.
With a market cap of only $10.11 million, Kinbasha trades at a pro forma P/E ratio of 1.46. At this point, you can probably see why I say Kinbasha has potential. Then again, I never look exclusively at a company's equity. I always examine the valuation of the entire capital structure. Note: I have annualized the most recent quarter's depreciation figure so as not to overstate it.
From an enterprise perspective, Kinbasha looks cheap on an EV/EBITDA basis and reasonably valued based on EV/EBIT.
In essence, what we have here is a typical leveraged equity situation, just taken to an extreme. Kinbasha's equity value is less than one tenth of its entire enterprise value, which results in a heavily compressed P/E ratio despite a relatively normal EV/EBIT ratio. Any change in the valuation ratio or the capital structure will have a disproportional effect on the value of Kinbasha's equity because the company is so cartoonishly leveraged.
Here's what I mean. Here is a range of values for Kinbasha's equity, determined by holding the capital structure and EBIT equal and changing the EV/EBIT multiple.
Kinbasha's operations must command an EV/EBIT multiple a little higher than 8.0 for the equity to be worth anything at all. (Below that, the equity is worthless and the debt is impaired as well.) But at higher multiples, more and more value accrues to the equity.
That's one lever by which Kinbasha's share price could increase. The market could decide to assign a higher valuation multiple, and the stock could be off to the races.
However, it's not the only lever. The other is debt reduction. Highly leveraged firms can often create value for shareholders simply by reducing their excess debt to a manageable level. As long as the total enterprise of the firm remains the same, free cash flow from operations that is applied to debt reduction increases equity value dollar for dollar. When the equity proportion of the company's enterprise value is so small to start, the effects can be dramatic. Compounding the effect is that debt reduction often reduces the company's bankruptcy risk, leading to multiple expansion.
Let's imagine that Kinbasha's operations continue to do well. EBIT grows at 3% each year for the next three years, to $15.02 million. In each of the next three years, Kinbasha uses its free cash flow to pay down debt: $10 million this year, $11 million the next year, and $12 million the year after that. At the end of the three years, net debt will have been reduced by $33 million to $84.01 million.
Using the same valuation multiples as before except with higher EBIT and lower net debt shows massive potential increases in Kinbasha's equity value three years from now.
That's the power of leveraged equities. In Kinbasha is successful in reducing debt and maintaining/growing EBIT, its shares could double, triple or more.
Of course, that's if things go as planned. Kinbasha's lenders could decide to foreclose at any time, shuttering the entire operation. Or they could observe Kinbasha's progress and choose to apply penalty rates, figuring the company could pay. That would crimp cash flow and slow debt reduction efforts.
Finally, Kinbasha itself could lose focus on debt reduction and choose to undertake another expansion. The company notes in its annual report that it would like to open another 15 pachinko parlors, three each year for five years. The company also notes this would require substantial capital, and the company will not proceed with its plans unless it can secure this capital. If the company is tempted to pursue equity financing at these levels, the resulting dilution would greatly reduce the potential returns from de-leveraging.
So there you have it. On one hand, Kinbasha is a deeply-indebted company in incurable default, relying on the mercy of lenders not to foreclose and cause a total loss for shareholders. Any decline in EBIT due to a poor economy, regulatory changes or changing consumer tastes would also destroy the equity's value. On the other hand, you have a company with strong cash flow and ongoing debt reduction, as well as lenders with strong incentives not to upset the status quo.
A total loss on one hand, and a multi-bagger on the other. Kinbasha's value proposition all depends on the respective likelihoods of these scenarios.
I think the chances are better than not that Kinbasha will succeed in deleveraging and will negotiate a debt restructuring with its creditors. Yet, the chances of total loss are material and this is not your ordinary equity investment. Proceed at your own risk.