Kinbasha Gaming International’s Extreme Leverage is Both Risk and Opportunity – KNBA

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.

Pachinko01

 

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.

Kinbasha Valuation

 

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.

Kinbasha Valuation EV

 

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.

EVEBIT Mults

 

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.

EVEBIT Mults 3 year

 

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.

No position.

 

This entry was posted in Uncategorized. Bookmark the permalink.

21 Responses to Kinbasha Gaming International’s Extreme Leverage is Both Risk and Opportunity – KNBA

  1. anon says:

    Any idea if they have publicly traded bonds/debt? Could potentially be a more interesting way to play this

    • otcadventures says:

      I don’t believe they do. The majority of the debt is bank debt. They disclose the top holders in the annual report. Mostly big names.

  2. Market Observer says:

    I think it speaks volumes to the markets if we have to reach down into a pile of crap just to find “value”. I wonder what’s the value of cash right now 😉

    Interesting read though!

    • otcadventures says:

      Not sure I agree that it’s crap, but it is certainly not your typical situation. It’s all about handicapping the risk. If there is a 30% chance of a complete loss and a 70 percent chance of a 100% return, that is a bet that many would find attractive.

  3. 8484 says:

    Hmm…well you have this straight from the horse’s (or in this case, management’s) mouth:

    “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 shows desire to pay down its debt (really the only way for equity holders to realize a gain), and instead wants to borrow more! Levered equities can provide excellent returns very quickly…as long as management cares to take the right steps.

    • otcadventures says:

      I agree that management’s plans are not beneficial to shareholders. However, management also says that it will not pursue these plans if financing cannot be achieved.

      “We estimate that we will need between $9 million and $11 million to open each new pachinko parlor and to operate the parlor until it is cash flow positive. We presently do not have the capital resources to acquire or open additional pachinko parlors. Therefore, to implement our growth plan, we will need debt or equity financing from third parties. It will be very difficult to obtain this financing because of our current financial condition and recent operating results. We can give no assurance that we will be able to obtain this financing at all or upon terms that would be acceptable. If we do not obtain additional financing to open or acquire one or more additional pachinko parlors, we will continue to operate with our existing parlors. “

      • 8484 says:

        Thanks for reply!

        And I know I’m nit-picking here, but do you think they might also choose to issue more shares if they can’t raise debt?

        “to implement our growth plan, we will need debt or equity financing from third parties.”

        • otcadventures says:

          I do think they could choose to issue shares, but it is unlikely. In order to raise enough capital to open one new parlor, the company would have to nearly double its share count. I don’t think Mr. Takahama would be willing to lose control of the company in order to open one additional location.

          I suppose they could conduct a rights offering. That would allow for existing shareholders to maintain their stakes while raising cash.

          If the company does choose to raise capital, I suspect it would be some sort of high yield bond issuance with warrants attached. It would be incredibly dilutive, which is why I hope the company is wise enough to delay any expansion until the debt is under control.

          The uncertainties of management and creditor behavior is why this idea is so high risk.

          • 8484 says:

            I really appreciate you posting such ideas and responding to each comment! Thank you!

            Regarding: “I suppose they could conduct a rights offering. That would allow for existing shareholders to maintain their stakes while raising cash.”

            I bet rights offering isn’t even on the management’s radar. If they had been so shrewd they wouldn’t even think about expanding.

            I’d much rather put more money in a sure thing like Awilco, where contracts are signed and the revenue + dividends are pretty much certain 😀

            I guess depending on one’s goals, etc one could put a % of his portfolio in ideas such as this one, but I’m not that type…

          • otcadventures says:

            Yeah, this company is not for me either. But sometimes I like to write up companies that interest me, even if they don’t wind up in my portfolio. After all, this blog is intended to be a starting place for research, not actual investment advice.

  4. lady 3jane says:

    Any reason why they listed or how they listed via reverse merger? Pachinko parlors cannot list in Japan and the industry generally has a pretty sketchy reputation (not entirely undeserved).
    Who are the lenders btw?

    • otcadventures says:

      They probably chose a reverse merger in order to spare the expense of a traditional IPO. This is a tiny company, and every dollar counts. I am not surprised to hear pachinko parlors cannot list in Japan, nor am I surprised to hear the industry has a less than squeaky clean reputation. I’d say that second-tier and lower casinos here in the US are the same.

      However, the top lenders appear to be reputable organizations.

      Higashi-Nippon Bank
      Morgan Stanley Credit Products Japan
      Jogashima Limited Liability Company
      Aozura Asset Company

      These four lenders hold nearly 60% of Kinbasha’s debt.

      • Lady 3Jane says:

        reason I ask who the lenders are as this generally tells you a lot about the business in Japan.
        You may have a multi-bagger here, but my experience looking at these type of sits in Japan is that the lenders normally flag if something funky is happening underneath and not sure I would call these guys particularly sterling in the Japanese context.

        Reputable organizations in Japan are the megabanks and the large regionals, possibly the tier two regionals. If the company has to borrow off foreigners or unknowns then would recommend some proper DD on the target and asking how or why they came to end up borrowing off them.

        Aozura (surely, aozora, no?), if it is the aozora I am thinking of, is a foreign PE owned bank – have a look at what these guys have lent to in the past.
        Jogashima I have never heard of… which suggests one needs to find out who the shareholders are of this lender.
        Higashi Nippon is a tier two regional based out of Tokyo (admittedly with ties to Ibaraki).
        Kinbasha have 18 stores in Ibaraki: that’s quite a decent chunk of operating assets. Which begs the question, why won’t Joyo or Tsukuba bank lend to them?

        BTW Dynam – a much bigger pachinko play – listed in HK. So reverse merger is not the only way to go… you could list in Singapore as well. A few Japanese names down there too.

        Slightly offbeat lenders, pachinko and a reverse merger into the US suggest the potential for something to be a little amiss. I think you may want to dig further on this one or make it a small position.

        • otcadventures says:

          Really appreciate your insights! I actually passed on investing in Kinbasha entirely. The upside potential is huge, but the risk of a total loss is unacceptably high.

  5. DTEJD1997 says:

    This is certainly an interesting situation!

    However, I would think twice, maybe even thrice before investing.

    The banks are the real owners here. At any point, they can put the kibosh on this company. The other thing is that the banks can enforce the terms of loans and take a huge portion of the earnings. They are not currently doing this, but I imagine they can change the terms to the original terms of the loans in the future if the company starts making significant money.

    The other HUGE red flag is that management is talking about significant expansion! What are they thinking? They are in technical default on their loans and they want to expand?

    If I were a skeptical investor, I would almost think that perhaps management’s interest is different than shareholders. Unethical management might be skimming off the top from each parlor. More pachinko parlors equals more skimming.

    I AM NOT SUGGESTING THAT IS THE CASE HERE. I think these are ethical guys…

    There have also been rumors for many, many years that North Koreans own a large percentage of pachinko parlors and are ingrained in the industry. That some of the money from pachinko flows back to North Korea.

    Again, I am not suggesting that is the case here.

    Very interesting though!

    • otcadventures says:

      Thanks for the comment! I agree, it’s an interesting situation but there are just too many potentially bad outcomes for me to get involved. I do think the risk of foreclosure is very low. Banks in Japan are very reluctant to foreclose on loans, especially those that are current on interest payments and regularly reducing principal.

      Management’s plans worry me a lot more.

  6. Micro Value says:

    Would you consider doing a write-up on Coda Octopus (CDOC)? It has a similar PE and a good deal of debt, but much less of a debt hole relative to a company like Kinbasha. I am surprised that I haven’t seen a single blog writeup about it…

  7. Hi …

    I have actually been in those pachinko parlors, and played them a few times (just like vertical pinball), (about 8 years ago) and seen the owners/managers …. interesting that many of the owners
    have those short punch perm haircuts …. which is a bit of a symbal of the rougher crowd of men in Japan …
    Almost like a bikers logo on the back of his vest…

    My main question, is why on earth would they do a reverse merger of an otc company in the US? I do not see any good reason,,,. A lot of great analysis has been done here, and great points raised, but I still do not see why they would do the otc reverse merger? unless it is a P&D deal…. just wondering…

    Thanks again for the very interesting analysis

  8. BRK.B says:

    Japan is set to authorize construction of a casino in Tokyo. That could mean game over for pachinko.

Leave a Reply

Your email address will not be published. Required fields are marked *