Donaco International: High risk, high reward?
With apologies to entrapped shareholders, I couldn’t help but laugh when I saw the recent Donaco International (ASX:DNA) AGM update. Trouble with Chinese gangsters, and one of the company’s larger shareholders and a former vendor of an asset Donaco bought, is threatening to cut off power and build a wall around Donaco’s largest asset!
I also couldn’t help but the think that Donaco is a clear high risk, high reward play. With the company now priced at ~1-2x ish historical EBITDA, half book value, and a low single digit multiple of historical NPAT, you don’t need a lot to go right to make money.
The bull case
I don’t really know what the company is worth, but let’s say the best case prices the company at ballpark 4x-8x FY18’s already weak EBITDA.
That puts the company’s implied market capitalisation at somewhere between $120m and $240m, which is between 2x and 5x its current mcap. If earnings of prior years’ (FY16 and FY17) are ever attained again, the market valuation will probably be twice that. Conceivably you could make 2x-10x your money in Donaco in a few years.
(the probability of achieving that is a different story entirely)
Donaco owns two casinos, The Aristo in Vietnam which does a lot of business with Chinese junkets, and the Star Vegas in Cambodia whose primary customers are Thai. The overwhelming majority of Donaco’s business is from Star Vegas, which is also where the biggest risks lie.
Donaco also has US$40m ish (? guesstimated) of debt and A$47m in cash. FY19 earnings will likely be substantially below last year’s level, if the first four months of trading are any guide (20% decline in revenue, 62% decline in EBITDA), although management states that will improve later in the year.
If you can make a case for earnings stabilising or recovering, you could make money here.
What grounds could there be for assuming earnings recovery? I would argue three possibilities:
- Management are taking a number of actions to lease vacant space, introduce new lines of revenue (online gambling) and source customers from new regions (e.g. Korea, Malaysia).
- In rational (and legal) competition between 3 casinos, the winner probably comes down to a few key factors: cost advantage (and marketing spend), quality of experience and ability to source customers (sourcing customers potentially being a competitive advantage). This is offset by illegal tactics of competitors, but still a win is conceptually possible for Donaco.
- Share price recovery is possible even with a moderately declining outcome if Donaco can stabilise financially, e.g. if investments start to cover start-up costs, and legal costs reduce.
- Bonus long shot opportunities (and costs + risks) in litigation.
The risks are hilariously bad – Chinese gangsters are chasing away customers in Vietnam, and the Thai vendor of Star Vegas (which Donaco bought ~3 years ago) is allegedly illegally competing with Donaco by running two casinos next door to the Star Vegas. The vendor has poached away a large part of Donaco’s business in addition to (allegedly) making various threats to damage Donaco’s business.
Donaco also has about fifty-leven million lawsuits and countersuits, fending off spurious lawsuits from the vendor as well as trying to sue the vendor in an arbitration process in Singapore (where the contract was written).
This underlying risks of all this are touched on in my recent post about ownership. Donaco has limited to no ability to guarantee its revenue (dependent on cross-border travel and wall-building, electricity-severing vendors and time consuming legal processes as they are). Offsetting this is the fact that management seems industrious at addressing the problems and taking action to rebuild the damaged business and add new lines of revenue.
There are also a couple of more serious risks. First is that, in my opinion, Donaco risks financial stress. Earnings in the 3-4 months in the lead-up to the AGM suggested a 20% decline in group revenue and a 62% EBITDA decline for that period. While management says that will improve over the coming months, if you extrapolate that kind of impact over a full year, the business could struggle to make mandatory loan principal repayments of US$8.5m every 6 months.
Relying on the A$47m cash on the balance sheet or a net debt position is also misleading in my opinion, as a large amount is tied up in the business (it’s a cash business – casino), some is restricted by the lender, and there are large payable bills within the next 12 month. According to management it will take 2 years to pay down the remaining debt, and obviously longer if business continues to decline. Debt matures in 2022.
Second, it is my view that management is not being frank with shareholders. The involvement of Chinese gangsters during July and August was not once mentioned during the August Annual Report, despite arguably being pretty material to the business. Obviously, less than frank management (despite large personal shareholdings) in this kind of turnaround situation makes it harder to assess the probability of a good outcome. While it’s early days, there are no signs yet of management buying shares on market or looking to recapitalise the company (e.g. cap raise/ convertible note).
Third, overall you would have to raise an eyebrow at management’s capital allocation and Asian operating savvy. Donaco shares have been a disaster for years (I first looked at the company in 2014 at $0.80). While bad luck can play a role, the alleged woes with the vendor are also a black mark for management in terms of their operating savvy. It must be the oldest scam in the world to sell someone something that they don’t “own”, in a region with a weak legal framework (note my post on functional ownership above). That’s assuming that the Thai vendor is actually involved, which of course he allegedly is not.
Management however has been quite shrewd to get involved with the community, giving out gifts and donating to charity following recent events.
In Vietnam I think the issues are likely solveable given the Viet government owns 5% of The Aristo.
As to Cambodia… who knows. To me at least, it looks as though the alleged wrongdoer is trying to force Donaco either to quit the area, or to go into financial stress and force an asset sale. Other points of weakness could be attempting to get casino licenses (renewed annually in Cambodia and I think Vietnam also) revoked, which would be extremely uncool and, assuming a politically connected protagonist, not an improbable outcome.
You’d also have to assume that casinos are not always frequented by saintly clientele.
The bottom line
Due to the relatively fixed costs of the business, generating additional revenue is highly rewarding and can grow earnings quickly. If you assume a return to normal business (whatever the chance of that is) then this company is crazily undervalued.
The downside is that a plausible, even likely outcome is losing 90-100% of your money. You could also make 2x-10x (very roughly speaking).
I don’t think the probabilities of those outcomes are really quantifiable, which is hard for determining risk vs reward. The tale of woe at the Star Vegas (on which everything hangs) is also filtered through the company, which puts an influence on the story.
Still, for those kinds of long-shot outcomes, I could make a case for making Donaco a tiny position and riding it in either direction. Too hard for me right now I think, but maybe one to watch. Food for thought.
I have no position in Donaco. This post is intended as a general description of the Donaco situation. I have not analysed the probabilities of any of the outcomes described above. I am talking in terms of possibilities, not probabilities. My info was pulled together pretty quickly and it is possibly incomplete or inaccurate. This is a disclosure and not a recommendation.
Lol. 4-8x EBITDA in an emerging market with weak regulatory framework… you obviously have not done casino M&A deals in emerging markets. Try 4-6x maximum. Other than that, a good post!