NagaCorp – The Action Is In This IndoChina Casino – Seeking Alpha

NagaCorp – The Action Is In This South-East Asia Casino

NagaCorp Ltd. (NagaWorld, Naga) (NGCRF.PK)

3918:HK

Note: NagaCorp’s primary ticker is 3918 on the Hong Kong Exchange, its principal trading venue, but Seeking Alpha does not permit linking to Hong Kong tickers.

Note: Dollar amounts are in US$ unless mentioned otherwise. USD-HKD 7.75 Price of 1 USD in HKD

NagaCorp runs a monopoly on gambling in Phnom Penh. Share of the casino operator has been on a bullish tear since its 2006 IPO and is up +81% year-to-date. In 2006, NagaCorp raised US$95 million with a Hong Kong stock offering at a price of HK$1.43 per share. Since then shareholders have been well rewarded; today shares of casino are trading ~HK$6.90, a whopping 383% not including dividends and special dividends.

The focus of this article is to determine if NagaCorp’s rally will continue. Is NagaCorp undervalued in relation to its intrinsic value?

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Naga vs. S&P 500 vs Hang Seng Index Chart: Yahoo! Finance

You can see from the chart above that Naga is outperforming the Hong Kong exchange, the bourse on which it’s listed, but also the S&P 500.

Before going too far into the details, I need to warn you that this investment research is unique. I normally would not feel the need to provide investors with a country-level background. However, given the uniqueness of Cambodia, as well as how relatively unknown and misunderstood it is to western investors, I think it is important to have a brief introduction. In this case, I find it both equally important to understand the company on a micro level as well as the overall state of the Cambodian economy.

Thesis

NagaWorld, the gambling arm of NagaCorp, is a luxury casino gaming resort located in the heart of the Kingdom of Cambodia. NagaWorld is Cambodia’s best known casino and Phnom Penh’s only licensed hotel-casino. The massive colorful building itself it is a magnet of attraction to Phnom Penh. Naga is also the first Cambodian company with operations to become a publicly listed company, as well as the first gaming IPO on the Hong Kong Exchange, the public portion of which was oversubscribed by 118 times. For the simplicity of the report I will often refer to the term “casino,” but NagaWorld is actually a massive leisure and business luxury complex. NagaWorld has 700 suites and deluxe rooms, 150 gaming tables, 1470 electronic gaming machines, 15 Food & Beverage outlets, meetings, incentives, conferences, and exhibitions (MICE facilities), and entertainment services (bars, clubs, karaoke, shows, spa…).

There are other casinos in Cambodia but none can match Naga’s offering. The majority of casinos in Cambodia are small affairs in grubby little border towns that cater to Thai, Chinese and Vietnamese gamblers since gaming is not permitted in their home market. Strong demands from these markets remain to be expected. Naga is controlled by foreigner Chen Lip Keong, also its CEO and one of the thirteen richest men in Malaysia according to Forbes. He is self-financing Naga2 and NagaCity Walk with a convertible bond which is expected to open sometime in 2015. There’s a whole section below on the Naga2 project.

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NagaWorld on the Mekong and Tonle Sap Rivers Source: NagaCorp

Based on my valuation, the implied intrinsic value of NagaCorp is US$3.9 billion or US$1.07 per share. This represents a 20% increase from US$0.89 a share (does not include dividends), the closing price on August 9th 2013. The target share price represents a fully dilutive share count assuming the Naga2 transaction goes ahead in 2016. The catalysts for growth are strong tourism growth in Cambodia, a favorable tax structure, strong demand for gaming, a monopoly environment, strong economic growth, an improved VIP segment, great management, a solid balance sheet and excellent financial performance.

Key Catalyst Drivers

NagaWorld is in a very favorable unique position and as mentioned above, it has many catalysts for growth. One major competitive advantage is that NagaWorld holds a monopoly right on gambling within a 200km radius of Phnom Penh until 2035. You can’t find a barrier to entry higher than that. Naga also has a 70-year casino license to operate. NagaCorp enjoys a favorable tax structure (~3% of gross revenues) and it’s important to mention that Cambodia is emerging from its dark past to become a popular tourist destination and economically successful.

NagaWorld’s success is highly based on these key drivers and I believe these catalysts will command the stock higher:

1. Exposure to tourism growth
2. Appetite for gambling and leisure
3. Focus on VIP segment
4. Monopoly on gambling
5. Favorable tax structure
6. Opening of Naga2 and NagaCity Walk
7. Concentrated Ownership
8. Financially Solid

• Tourism

NagaWorld is highly dependent on the travel industry. Naga’s main customers are foreign tourists, especially the Vietnamese and the Thais. Since it’s illegal for the Thai and the Vietnamese people to gamble in their own countries, they don’t mind taking a bus ride or a short flight over to have a little fun. It certainly helps that the Vietnamese benefit from a visa-free access to Cambodia. To accommodate the Vietnamese, Naga is now offering a luxury bus program to further penetrate the Vietnamese market to have more Vietnamese visit Cambodia. NagaWorld provides six trips a day from Ho Chi Minh City to Phnom Penh and back. In 2012, Vietnam ranked first in terms of the number of tourists visiting Cambodia at over 680,000, or 19 percent of all international visitors. 40% of the casino’s clientele came from Vietnam, while 25% were Cambodians with valid passports. The Company will expand the bus service to two other Cambodian destinations, Siem Reap, home to Angkor Wat and the number one tourist destination in Cambodia, and Sihanoukville (where the country’s biggest port is located). Regarding Thailand, Naga introduced new initiatives to raise penetration into Thailand in 2012, including a new office and promotions are in the mix. At the moment, Thailand accounts for just a fraction of the current mass market at Naga.

For the tourists arriving by air, NagaCorp is planning a private VIP terminal costing US$15 million is being planned at Phnom Penh International Airport, which hopes that once it is ready, high-rollers would flock to its casino and double their spending to US$8 billion. According to the press release, the new terminal “will be located at a different location from the existing passenger terminal,” and “would house its own immigration facility, VIP lounge, food and beverage outlets and other services.” The terminal is expected to be completed by the end of 2013 or early 2014.

There’s a section below dedicated to more in-depth tourism data. The number of tourist arrivals to Cambodia increased by 24.4% to 3,584,307 visitors in 2012 when compared to 2011. Breaking it down further, of the 3.5m annual visitors, about 1.75m arrived via air, and of this group, 46% arrived in Phnom Penh (the capital and home to NagaWorld) and 54% arrived in Siem Reap. It is expected that 5 million tourists will visit Cambodia in 2015, and 7 million in 2020 according to the Ministry of Tourism Cambodia. There are a total of two international airports (Phnom Penh and Siem Reap) and one domestic airport (Sihanoukville) in Cambodia. The Cambodian government is in the midst of increasing the capacities of both international airports to double its existing capacities by 2015, with plans to add a new international airport in Phnom Penh by 2020.

To resume, NagaWorld’s exposure to Phnom Penh’s tourism growth in the coming years will lead to greater traffic, especially in the high margin mass-market tables.

• Gaming Demand

Anybody that has been in a casino and has witnessed an Asian person gamble understands the seriousness of gambling. I am over generalizing but for some Asians gambling is serious business. Tales of gamblers spending days at a table in the same clothes are not an exaggeration. Cambodia and Vietnam has a strong gambling culture, even though it’s illegal. Cambodians love to gamble and they are frequently seen taking bets on the weather and dice rolls. Gambling is a social “evil” that fuels poverty and generally nothing good comes out of it. Nonetheless gambling, the fantasy of easy money is fun and very addictive. Morality, religion and the desire to protect their citizens explains the ban on gambling all over Asia, except of course for foreigners. The polar opposite is true regarding foreigners. It seems that casinos are trying to extract as much money as possible from foreigners. Seeing an opportunity for new income, most Asian countries operate casinos – the majority of them on the border – with the goal of attracting the next door neighbor and their money. Basically, gambling is only a social “evil” when it’s your own citizen doing the gambling, therefore Cambodia doesn’t mind taking Vietnamese money, Vietnam doesn’t mind taking Chinese money, Laos doesn’t mind taking Thai money, and Macau doesn’t mind taking everyone’s money. The appetite for gambling is certainly not going away and that’s where NagaWorld comes in. Naga has built this monopoly leisure hub with access to gaming, entertainment, exotic cuisine and luxury shopping. If you are ever in Phnom Penh, Naga is a tourist destination on its own, it’s very hard to avoid since its giant buildings is a strategically located landmark in the middle of the city.

• High Rollers

NagaCorp has started a revenue sharing program with its junkets where Naga receives 30% of wins and the junkets receive 70%. About 80% of the junket rolling chip volume is currently under the revenue sharing program. In addition, five junkets have been signed up for the new VIP hall area where the maximum bet has been increased from US$24k to US$100k per hand. These luxury suites are a prelude to Naga2, which will feature 50 of these suites. With a higher table limit, Naga is able to target a more aggressive VIP player which should lead to improved win rates. With the 70% revenue split to junkets, management is aiming to entice sub-junkets in China to bring Chinese VIP players to NagaWorld.

• Monopoly

NagaWorld has a casino license valid for 70 years that runs until 2065. NagaWorld also holds a 200km radius monopoly right on gaming in Phnom Penh. This exclusive designated area is valid until 2035. These two key ingredients provide a fortress around NagaWorld’s income. As long as Phnom Penh can attract tourists, NagaWorld will hold a certain degree of control on entertainment. If that monopoly status ever expires, it will take at least $US1 billion to get in the game. (Estimated cost of building a casino similar to NagaWorld + Naga2)

• Favorable Tax Structure

Naga also has a favorable tax structure that is expected to remain in place until 2018 (US$426k/month during 2013, rising 12.5% per year), equating to ~2-3% of gross revenues, well below the 20% statutory corporate tax rate in Cambodia and that of other gaming jurisdictions, such as Macau at 39% gross gaming revenue (GGR) and Singapore at 17%. It is fair to assume that the tax rate will increase following 2018 if you take into consideration the calls from the opposition and the government’s thirst for revenues. Naga is currently in discussion with the government to extend the tax agreement beyond 2018.

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Source: NagaCorp data

• Naga2 and NagaCity Walk

There’s a whole section below dedicated to Naga2. Briefly, Naga2 will broaden its luxury retail footprint and its gaming hotel offering. NagaWorld will be twice as big and might have more of an impact in the region in attracting VIP clientele.

• Concentrated Ownership

I have a preference for companies where management has tight concentrated ownership position. In my opinion, these represent the optimal situation where shareholder and management interest are aligned and as a result there’s better chance for long-term wealth creation. There also seems to be a focus on the long-term plan instead of trying to meet overzealous quarterly targets. In the case of NagaCorp, Dr. Chen Lip Keong, founder and CEO, owns approximately ~42% of the underlying shares at the moment and this amount will increase to ~65% once Naga2 is completed. The target date is June 12th 2016 to fulfill the conditions related to the project. Top management has been the same for years and its track record has been outstanding. Management has my vote of confidence.

• Financial Solid

NagaCorp has historically delivered solid financial results. It has been profitable every year since its public debut and has consistently distributed over 50% of profits (70% 1H-2013) while managing to keep the company growing. Shareholder’s equity has grown from US$215 million in 2006 to US$566 million as of June 30th 2013. Dividend distribution grew from US$28 million in 2006 to US$80 in 2012. Revenues are expected to top US$300 million this year, up from US$85 million in 2006. In 2012, 41% of NagaCorp’s revenues are generated from slot machine business (gross profit margin: 95%), and 28% of revenues come from the mass-market segment (gross profit margin: 95%). It’s also important to note that NagaCorp has no debt, therefore no interest expense. NagaCorp reported a net profit of US$113.1 million for 2012 and achieved healthy growth in all its business segments. Naga achieved these results in the midst of a sluggish global economic recovery as gaming throughout the Asia Pacific region maintained its dominance on the global stage. Not bad for a region where gambling is illegal.

NagaCorp Description and History

In 1994, NagaCorp opened its first casino on a barge in the Mekong River. Two years later, the company saw its initial 20-year gaming license extended to 70 years. The license also gives NagaCorp exclusive rights to casino gambling within a 200-kilometer radius of Phnom Penh until 2035.

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Source: NagaCorp

The casino moved on shore in 2004, and in 2006, NagaCorp raised US$95 million with a Hong Kong stock offering, the first Cambodian company to list internationally, helping to open the country to foreign investment. In March 2012, NagaCorp market capitalization touched the US$1 billion mark.

NagaCorp reports that its full-year 2012 revenue rose 24.6% to US $279m while net profit rose 22.9% to US$113 million. According to Patrick McNally, Naga’s Chairman, “We brought pride to Cambodia, prestige, showed confidence in Cambodia, and raised the visibility of the country and the company. We were confident the story would become monumentally better, like the country.”

What is NagaWorld?

NagaWorld consists of some 1 million square feet (sq ft) with over 700 Suites and deluxe rooms, 150 gaming tables, 1470 electronic gaming machines, 15 Food & Beverage outlets, meetings, incentives, conferences, and exhibitions (MICE facilities), and entertainment services (bars, clubs, karaoke, shows, spa…). The summary table below does not show the upcoming Naga2.

What’s Behind the Name

Not financially relevant but interesting. According to Naga’s corporate website, the meaning behind the name is:

According to legend, NagaWorld derived its name from the mythical fable of a 7-headed dragon or “Naga.” The majestic dragon was believed to be residing in the rivers and guarding the entrance to Phnom Penh. The tale revealed its only sighting during the appearance of a rainbow and was thus considered highly auspicious. Reminiscent of a pot of gold at the end of a rainbow, NagaWorld was likened to a promising symbol of new beginnings and prosperity.

Naga2

Situated 200 meters from the existing NagaWorld, Naga2 calls for an ambitious 1.2 million sq ft expansion plan with two 5-star hotel blocks, a podium block, and at least double the gaming capacity, plus Phnom Penh’s first modern luxury mall. The US$369 million project also includes a waterfront public park and a third tower that will be given to the government for offices (It’s important to keep the government happy). The ground breaking ceremony was in November 2012 and the expansion is expected to be completed by the end of 2015 or early 2016.

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Concept picture of Naga2 Source: NagaCorp

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Naga2 is coming together and is expected to be completed in 2015-2016. Source: NagaCorp

The first luxury hotel will have more than 1,000 rooms housed in a 24-storey block with a rooftop pool. The second hotel consists of 50 VIP luxury suites spread across 22 floors, a first for gamers anywhere in the world according to NagaCorp. Another highlight of Naga2 will be the 200,000 sq ft of retail space which stretches from NagaWorld to Naga2, also known as the NagaCity Walk. This distinctive mall will offer a spectrum of luxury fashion shopping boutiques, as well as top restaurants.

The expansion was approved by 85% of the independent shareholders in January 2012. The move was necessary to cater to the growing demand for gambling in the Indochina and Greater China area. Naga2 will sharpen the company’s competitive edge in the Asian entertainment gaming market, especially in light of new and developing integrated gaming projects underway in Vietnam, the Philippines, and Macau.

Naga2 will consist of three components: the TSCLK Integrated Complex, NagaCity Walk and a Tourist Park, with the following sub-components:

The project is developed by NagaCorp CEO and controlling shareholder Chen Lip Keong independently of NagaCorp. Upon completion, the projects will be acquired by NagaCorp in exchange for convertible bonds worth US$369 billion at a conversion price of HK$1.8376 (US$0.24) per share. In the last year, Chen Lip Keong reduced his stake in Naga twice to pay for the project. According to a filing, Chen Lip Keong believes that building the project independently reduces risk for NagaCorp. “NagaCorp will not need to bear the development funding, cost escalation and completion risks are borne by Chen Lip Keong”. Also in the filing: “In the event of cost overrun, the consideration will still be capped at US$369,000,000 and there will not be any pricing adjustments for actual increment of costs incurred by Chen Lip Keong,” while lower actual costs will also not result in a pricing adjustment.

Chen Lip Keong currently holds 42% of the issued share capital of NagaCorp, but he will end up with approximately 65% upon conversion of the bonds following the completion of the projects.

Recent Highlights and Developments

• On June 28th 2013, the Phnom Penh Court has ordered 400 workers back to work after a two week illegal strike. The staff is demanding a pay raise from $80 to $150 (87.5% raise) a month and improved working conditions. The strike is not the first one at NagaWorld and future strikes are probable. Many companies in Cambodia are affected by labor strikes. The negotiations are on-going. There are signs that the industrial strife may have briefly impacted investor confidence in the casino. Before the strike, on June 11th, NagaCorp was trading for HK$6.12, or about US$0.79. On June 25th, the NagaCorp shares dropped to HK$5.50 but has rebounded since. The share price is still far above its value of HK$4.74, or about US$0.61, at the start of 2013.

• U.S.-listed gambling firm Entertainment Gaming Asia Inc. (NASDAQ: EGT) opened a second casino on the Thai-Cambodia border, called Dreamworld Poipet. EGT has invested $7.5 million in the new project, which houses 300 gaming machines in a nearly 1,500 square meter site. EGT opened its first Cambodian gaming venue, Dreamworld Pailin in May 2012. A third casino, Dreamworld Kampot is set to open in the next few months. EGA is backed by Macau-based Melco International Development Limited, also supplies slot machines to the NagaWorld and Thansur Bokor casinos (Kampot).

• On July 26th, Vietnam’s The Grand – Ho Tram Strip Casino opened. The first phase will feature a 541-room five-star hotel along with gaming facilities, ten bars and restaurants, three swimming pools and luxury retail shopping. The second phase, which broke ground in October, will add 559 rooms and more leisure and convention facilities. American gaming operator Pinnacle Entertainment, which holds a 23% stake in ACDL, will operate a second casino within the development. The casinos will only be accessible by foreign tourists and Vietnamese nationals holding foreign passports.

• In a 2012 deal, the Cambodian government sold off more than 130 square miles of a national park, Botum Sakor National Park, to a Chinese developer, Tianjin Union Development Group. The group is planning a city-sized US$3.8 billion complex with a casino named after the fabled Angkor Wat.

• Russia? – Naga was shortlisted as one of the most preferred tenders for the Primorye Integrated Entertainment Zone (Vladivostok, Russia) in December 2012. However, not much is being disclosed and more clarity is required. As far as we know, it’s purely discussions. Link: http://www.iezprimorye.com/news/87/

Interesting Facts

• According to a report by EBS International, NagaCorp aims to more than double the spending by VIP players, from $3.8 billion last year to $8 billion in about three years. This is also management’s target.
• NagaCorp currently has at least one private jet that is used to fly VIP customers into the Kingdom.
• 58% percent of NagaCorp revenue came from mass market gamblers, who provided a stunning gross margin of 94 percent; VIP margins were a still-healthy but far-lower 37 percent.
• The total investment cost of NagaWorld was approximately US$290 million as of December 31, 2012.
• The sharp decrease in the first quarter of 2013 was mainly due to the week-long funeral of Cambodia’s late King Norodom Sihanouk in February and a NagaWorld employee strike.
• Naga raked in a record $113.1 million net profit in 2012, 23 percent higher than in 2011.
• Forty percent of the casino’s clientele came from Vietnam, while 25 percent were Cambodians with valid passports.
• Macau has six licensed casino operators : Wynn Macau Ltd (1128.HK), Sands China Ltd (1928.HK), Galaxy Entertainment Group Ltd (0027.HK), SJM Holdings Ltd (0880.HK), MGM China Holdings Ltd (2282.HK) and Melco Crown Entertainment Ltd (MPEL.O). Macau’s revenues totaled US$38 billion last year – six times that of the Las Vegas strip. A lot of that can be credited to its unique VIP junket system, where licensed middlemen act on behalf of the casinos to attract “big whale” spenders by arranging their travel and accommodations and handle their gambling credit.

Cambodia

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Source: Google Maps

I normally would not feel the need to provide investors with a country-level background. However, given the uniqueness of Cambodia, as well as how relatively unknown and misunderstood it is to western investors, I think it is important to have a brief introduction.

Today’s Cambodia began twenty years ago with the 22,000 UN peace keepers stationed in the country supervising a civil war cease fire and an election. Cambodia has been around for over a thousand years but mention Cambodia and images of the Khmer Rouge come to mind. The country certainly struggled from an image problem and the international media is certainly not helping. Today’s Cambodia is not your parents’ Cambodia and the country has gone a long way improving the conditions of its citizens.

Cambodia is currently classified as a frontier market and is high growth hot zone (~7% average over the last couple years, see table below). It has low correlation to developed markets, excellent upside potential, and exhibit strong potential to transform into mainstream emerging markets.

While the population has grown to 15.2 million today, the median age is just 23.7 years old, while 96% of the population is below the age of 65, a very favorable investment demographic. Cambodia remains very poor by western standards, although GDP growth has been notable over the past decade. Current GDP for the entire country is about US$14 billion annually and GDP per capita is just $2,400 (PPP). The primary industries of Cambodia are tourism, textiles, agriculture and construction.

It’s often said that Cambodia is the Thailand of 30 years ago. There’s some truth to that except that Cambodia is much smaller in population and size. Cambodia also started behind in their fresh economy start since the country emerged from a long bloody civil war while Thailand was never colonized by the French or the English. Cambodia is sandwiched by richer neighbors (Thailand and Vietnam) and some of that wealth gets to spill over into Cambodia.

Economic Stats

The state of the overall Cambodian economy plays a big role in the investment decision. To understand where Cambodia is going you need to understand where it comes from. Even though NagaCorp is a stand-alone company, where the Indochina economy is going is where NagaCorp is going. Cambodia began to return to peace in 1993. It became a member of ASEAN in 1999 and WTO in 2004. I have included basic statistics on Cambodia and I used Thailand as a proxy for potential growth.

Snapshot

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Source: The World Bank & CIA World FactBook

You can see from the chart above that Cambodia has a very young emerging population with the median age of 23.7 years, a very favorable demographic with cheap unskilled labor. Some of the variables such as the infant death rate might look depressing but it tells us that there’s a lot of progress left to be accomplished. Cambodia is also characterized by its untapped natural resources, underpenetrated consumer market, and unleveraged position.

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Source: Ministry of Finance Cambodia

Cambodia’s growth has no correlation with the problems of the Western world. After the decline of the financial crisis, Cambodia rebounded and is growing strong.

Investment Environment

Cambodia has a stable government with favorable investment policies. After emerging from its dark past, Cambodia has begun to solidify the remarkable progress it has achieved since adopting free-market economic policies in the 1990s. From 1998 to 2007, Cambodia’s GDP growth ranked sixth in the world and fastest in the Far East after China. Cambodia allows 100% ownership, except land; where 99-year land leases are available.

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Sources: IFC, 2012 Economic Freedom Index, Transparency, Moody’s, The UN’s Word Investment Report

Foreign Direct Investment (FDI)

As Cambodia’s international profile has risen, FDI into the country has also increased. Foreign investors have generally been treated well in Cambodia and the government has not gone back on contract terms and incentives offered. According to the independent Political & Economic Risk Consultancy, Ltd. (PERC) there have not been many disputes that have actually involved the local court system, but those in the hotel, garment, real estate, and financial services sectors, as well as embassy officials of foreign governments and managers of NGOs are positive about the government’s treatment of foreign investors. Moreover, there is little likelihood that the government will change in ways that fundamentally alter the environment for foreign investors for the worst. There have been no examples of nationalization or expropriation, nor are there likely to be. The civil and political environments are stable and likely to remain so.

FDI in Cambodia grew a whopping 73 percent in 2012 from the year before, a huge increase from US$1.6 billion in 2012, compared with US$902 million in 2011, according to UN group’s World Investment Report. The increase is largely credited to businesses looking to invest in the inexpensive, labour intensive garment and manufacturing industries, as well as rising production costs outside of Cambodia. The firms expanding operations in Cambodia are the same firms that moved to Thailand some 20 to 25 years ago and are producing the same products.

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The UN’s Word Investment Report

Cambodia has no restriction on capital flow and it’s easy to repatriate profit. This is a major advantage because in certain frontier markets, foreign investors must obtain permission to take dividends or capital gains out of the country. Following the 1997 Asian Financial Crisis, many Asian countries adopted stricter capital control policies. Cambodia spares you that headache.

Indochina Region

I find it important to incorporate the macroeconomic data of the surrounding region since Cambodia highly depends on the welfare of its neighbors. A richer Vietnam and Thailand can only help Cambodia. The data provided by the IMF tells us that the Indochina region has a rich history of high growth and further progress is forecast as well. The Indochina region has been somewhat insulated from the economic slowdown in the developed world, as a result of vibrant organic growth within the region. The main factors behind the strong economic data are favorable economic liberalization policies, higher trade with the world economy, a young growing population, and a lot of foreign direct investment. The whole region reminds me of a young Brazil or China before they were famously called the “BRIC.”

The charts below provide the historical and forecast GDP growth rate.

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Tourism Data

The gambling industry is heavily dependent on the tourist industry and in 2012 over 3.5 million tourists had visited Cambodia. It is expected that 5 million tourists will visit Cambodia in 2015 and 7 million in 2010. Siem Reap is the country’s number one destination since it’s home to the famous Angkor Wat temples.

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Source: Ministry of Tourism Cambodia, provided by NagaCorp

The total number of tourist arrivals increased by 19.0% to 1,791,187 visitors in the first five months of 2013 compared to the same period in 2012.

Of the top 10 visitors by country, Vietnam was the highest at 19.0%, followed by Korea (12.0%), China (11.3%), Lao PDR (8.2%), Thailand (5.4%), U.S.A. (4.8%), Japan (4.7%), Russia (3.6%), France (3.3%) and U.K. (3.0%).

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Source: Cambodia’s Ministry of Tourism

NagaCorp’s Key Executives

The information on the management bio is provided from the NagaCorp corporate website and Forbes’s Malaysia’s richest people. I have included the three key people.

President & CEO, Founder – Tan Sri Dr Chen Lip Keong (“TSCLK”)

Doctor-turned entrepreneur, Tan Sri Dr Chen Lip Keong (TSCLK), is a noted business figure with over 30 years of business experience in interests covering Property, Manufacturing, Gaming & Hotels, and Oil & Gas in South East Asia. He is Malaysia’s #13 richest men in 2013 with an estimated fortune of US$1 billion.

Dr. Chen is currently the founder and controlling shareholder, CEO of NagaCorp which owns the largest hotel gaming company in Cambodia. Dr. Chen also controls some other publicly listed companies ranging from resorts in East Malaysia, a factory in Kuala Lumpur and sizable property interest in Malaysia. From 1995 to 2002, Dr. Chen also served as the chief executive of an aerospace, Malaysian government-owned company which manufactured the first composites plane (Eagle). Dr. Chen has now teamed up with Thai government-controlled PTTEP International Ltd, to carry out E & P (Exploration & Production) of oil & gas in Cambodia and Thailand.

Dr. Chen graduated from the University of Malaya with an MBBS in 1973. In recognition of his various economic services to Malaysia, Dr. Chen has been conferred with various titles including the titles of “Dato” and “Tan Sri.” Since June 2001 to-current, Dr. Chen has served as an economic advisor to Hun Sen, Prime Minister of the Cambodian Government and in 2009, Dr. Chen was promoted as the Advisor to the Royal Government of Cambodia.

We note that Dr. Chen owns or controls approximately 42% of the outstanding shares of NagaCorp. 2012 compensation: $US720,000

Chairman: Timothy Patrick McNally

Mr. Timothy Patrick McNally joined the Company as the Chairman of the Board in February 2005. From April 1999 until October 2005, Mr. McNally was the Executive Director of Security and Corporate Legal Services for the Hong Kong Jockey Club (CLUB). In this capacity, Mr. McNally was a member of the executive Board of Management of the Club. Mr. McNally’s responsibilities include physical security matters; information security; internal investigations; racing licensing matters; membership vetting; corporate governance matters; liaison with law enforcement and legal services for the Club.

He is currently an international security consultant under the name Tim McNally and Associates. Prior to his involvement with the Club, Mr. McNally was a special agent of the FBI for 24 years (1975-99). Mr. McNally’s career focused on the investigation and prosecution of serious crime, particularly organized crime, drug trafficking, corruption and fraud matters. He also was assigned for two years as a legislative counsel by the FBI to handle issues arising with the US Congress on budgetary and oversight matters. He subsequently held several senior positions within the FBI including heading the organized crime and drug investigative programs in the Miami, Florida office from 1984 to 1991. He served as Deputy Director of the National Drug Intelligence Center 1992-93; subsequently headed up the Criminal Division of the Washington DC field office; served as the Agent in charge of the Baltimore, Maryland office (1994-96); and concluded his career with the FBI as the head of the FBI’s second largest field division in Los Angeles, California.

Mr. McNally is a member of the International Security Management Association; the National Executive Institute; and the Society of Former Special Agents of the FBI. He is a graduate of the University of Wisconsin-Eau Claire, receiving a Bachelor’s degree in Political Science in 1969. He was also granted a Juris Doctorate degree from Marquette University Law School in 1973 and was admitted to the State Bar of Wisconsin in June 1973.

2012 Non-executive Director compensation: $288,000

Gaming Business Overview

The gaming industry in Cambodia has been developing since 1994. As you might know by now, Cambodian citizens are forbidden from attending and playing at casinos unless they carry an additional citizenship (foreign passport). The gambling industry is heavily dependent on the tourist industry and in 2012 over 3.5 million tourists had visited Cambodia. As mentioned above, it is expected that 5 million tourists will visit Cambodia in 2015 and 7 million by 2020. I could only find two corporations engaged in the gaming industry in Cambodia with respect to which public information is available – Entertainment Gaming Asia Inc. and Queenco Leisure International (London: QLI). EGT is a provider of electronic gaming machines to Naga and also operates 2 casinos in the region. QLI operates the Holiday Palace Casino in Sihanookville and also have a major development in progress.

I don’t have Cambodia specific forecast on the gaming industry but for the last two years PricewaterhouseCoopers has been providing forecast for the South East Asia region. The picture below tells us that Asia Pacific will be the fastest-growing region in the world for casino gaming spending over the coming five years. NagaWorld is well positioned to take advantage of that growth; however, most of that growth will be fueled by Macau and Singapore, the two major gambling hubs.

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Casinos and Cambodia

Gambling, in any form, is illegal in Cambodia for citizens, according to the Law on the Suppression of Gambling adopted by the National Assembly in 1996. Still the Cambodian government certainly likes the income it provides since the industry brings in over US$25 million in taxes. State coffers are expected to see a 25 percent year-on-year increase in tax revenues from casinos, according to Cambodia’s Ministry of Economy and Finance. Naga is currently paying US$426,000 per month in taxes with a 12.5% yearly increase.

Hun Sen, the prime minister of Cambodia, told the nation’s parliament in August 2012 that the decision to allow the construction of casinos along the border with Vietnam was part of a “secret strategy” to prevent Cambodia’s occasionally combative neighbor from violating Cambodia’s sovereignty. Since 2006, the two nations have been painstakingly demarcating their shared border in a bid to quell territorial disputes left over from the French colonial period. Cambodia has multiple casinos along its borders with Vietnam and Thailand, which have occasionally made headlines due to luckless gamblers being a victim of the local loan sharks.

Hun Sen said: “I don’t like casinos, but the biggest goal for giving permission to build casinos is to protect the border. One can remove border markers, but one can’t remove five-story hotels. Don’t be stupid. You force me to talk about it. This should be a secret strategy to protect the nation.”

Growing Competition

Gambling and casinos are a huge money making business in Asia. Gambling has explosive regional growth. Regional Cambodia and its neighbors are all racing to open new casinos, especially near borders to snag the neighbors that aren’t allowed to gamble in their homeland. Macau is the big player in the region with 2012 revenues of US$38.1 billion which gets more than 80 percent of its visitors from Hong Kong and mainland China. Singapore and the Philippines aim to surpass Las Vegas. Cambodian developers are betting that casinos can make the tiny Southeast Asian country a bigger draw for high-spending tourists.

Entertainment Gaming Asia

EGT is a US listed publicly traded company engaged in providing: 1) electronic gaming machines (EGM); 2) the development and operation of gaming properties under the Dreamworld brand; 3) the design, manufacture and distribution of gaming chips and plaques.

EGT is the main provider of slot machines to NagaWorld and operates 3 casinos in Cambodia, 2 on the Thai border and the third one will open on the Vietnam border. As of December 31, 2012, EGT had 670 EGMs placed at NagaWorld, representing 46% of EGT total EGMs placed under their slot business, and those machines are among our highest performing units on a net win per day basis.

EGT has a market capitalization of about $50 million with 2012 revenues of US$32.8 million. Over US$14 million of that revenue – 43% of the company’s total sales and 76% of slots’ total revenues – came from slot machines on the NagaWorld floor, in which EGT and Naga operate a revenue-sharing agreement. EGT’s agreement to provide slots to NagaWorld expire in 2016 according to EGT’s 10-K. EGT believes it has a good relationship with NagaWorld.

Cambodia

Thansur Bokor Highland Resort

Thansur Bokor Highland Resort is located on the top of Bokor Mountain, two and half hour south of the Cambodian capital of Phnom Penh, opened in spring 2012. The complex is built by the Sokimex Group/Sokha Hotel Group, a Cambodian conglomerate that controls much of the country’s oil industry. The main question is how many serious gamblers want to make the two hour and half hour trek up the mountain. Early reviews (Trip Advisors) seem to suggest that other than the nice view, there isn’t much to do around there. The initial impressions are: “People go for the national park to end up stuck in a huge empty resort.” At the moment, this casino should not be of concern to NagaWorld. Below is a concept picture of the new Thansur Bokor Resort. http://www.thansurbokor.com/

Source: Thansur Bokor Highland Resort

Angkor Wat by the Sea

NagaWorld’s biggest competitor is probably under construction. The Tianjin Union Development Group (Union Group), a real-estate company from China, is transforming 340 square km of Botum Sakor into a city-sized gambling resort for “extravagant feasting and revelry,” its website says. A 64-km highway is now almost complete. A US$3.8 billion investment is expected and people in the area are referring it as Hong Kong II or the next Macau, but its real name, according to the website is “Angkor Wat by the Sea.” Union Group has big ambitions for the area, including a network of roads, an international airport, a port for large cruise ships, two reservoirs, condominiums, hotels, hospitals, golf courses and a casino. Company corporate website: http://www.tianjindev.com/

Queenco Leisure International

Queenco Leisure International Ltd. (QLI), an emerging markets developer and operator of casinos and entertainment centers, is planning major developments in Sihanookville. QLI currently operates the Holiday Palace Casino and is planning on building a 2,000-room hotel and casino resort and condominium complex, which will include a shopping mall, convention center, spa and restaurants. Construction is set to begin in 2013. The company is listed in London and Tel Aviv, London: QLI.

Vietnam

In Vietnam, the government is slowing changing their attitude towards gambling and is starting to get their feet wet with major gambling complex. Vietnam has one large casino opened and two more in development. The Grand-Ho Tram Strip just recently opened, Vietnam’s biggest ever tourism development, the island of Pho Quoc Casino is a US$4 billion development, and Las Vegas Sands wants to open a mega casino in Ho Chi Minh City. The Grand -The Ho Tram Strip’s link: http://hotram.asiancoastdevelopment.com/. But the gambling business in Vietnam is not after the Vietnam Law Office threatens Ho Tram with lawsuit over contract non-compliance days after the grand opening.

Like Cambodia, it’s illegal for locals to gamble, so they too have to rely on tourism. In order to gamble, Vietnamese must either fly to Macau, Singapore, the Philippines or drive across the border into Cambodia. Data from early 2011 indicates that there are currently 43 establishments that offer electronic gambling in three-star-or-better hotels and tourist spots primarily located in Ho Chi Minh City or Hanoi. However, no new licenses have been issued since 2007 after locals were discovered gambling in some of the existing establishments.

Laos

It’s also illegal for locals to gamble in Laos so they have to heavily rely on foreign tourists such as the Thai and Chinese. In fact, according to The Nation, more than 6,000 Thais are heading to Laos-based casinos each day. Laos’s gambling industry has been rocky lately after the closing of a casino in the Chinese run special economic zone (SEZ) after a crime shoot up. It’s difficult to have an update on the state of the gambling industry in Laos. Research indicates that it has three major casinos with sizable hotels, one near China and two near Thailand and Myanmar, and it had a number of border slot venues and minor gaming sites. One of the main casino sites in Laos has been the Savan Vegas. It is situated on the Mekong River across the second Thai-Lao Friendship Bridge in Savannakhet, a border town about an hour flight from Bangkok. The Savan Vegas has been hit with a surprise US$23 million tax bill. Savan believes that the claims are without merits and the taxes don’t have to be paid. The 2nd main site is King Roman Casino, located in the Golden Triangle. The Lao government has given it a 40-year lease of 827 hectares for development.

Myanmar

Up to date information is hard to find and according to information from 2011, Myanmar already has a few casinos-eight on the border with Thailand and a handful on the border with China. But they are generally gambling halls with a few hotel rooms aimed at the Thais and Chinese. It’s very hard to have up to date accurate information. A well-known casino is located on the Burma-China border in Mong Lah. It’s unclear at the moment if it’s open or closed after complaints from Chinese officials. Mong Lah emerged from a small remote village in the 1990s with the desire to become a Myanmar version of Las Vegas.

It is believed that Myanmar is reviewing their gaming law since tourism is set to explode. Casinos that operate legally in Myanmar are part of a hotel or resort with a number of amenities such as restaurants, bars and nightclubs. But legality of gaming remains questionable and illegal junkets are common.

Brief List of Casinos

I have included a brief list of the current casinos in the area. The list is far from complete since accurate information is scarce. Casino activity on the borders fluctuates a lot with frequent opening and closing, sometimes within the same year. I have also encounter a lot of different data regarding the number of licenses issued by the government ranging from 25 to 61. I assume the correct number is more towards the latter since there are over twenty casinos operating alone on the Cambodia-Vietnam border.

Many casino projects are also on the rise in Cambodia. Aside from NagaWorld, there are a few on-going large scale developments such as the Queen Leisure project in Sihanookville and the Union Group development in Botum Sakor. The casinos are still under development and I can’t calculate the effects it will have on NagaWorld. As mentioned earlier, NagaWorld benefits from a monopoly status in the Phnom Penh and surrounding region.

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Financial Review Revenue

Let’s review what NagaWorld has accomplished and where it’s heading. The first metric, a basic one, is revenue. The chart below portrays the revenue of Naga for the last ten years.

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We can see from the chart above that Naga had monster growth in the last ten years. Since their IPO in 2006, revenue grew from US$85.4 to US$278.8, that’s a 226% increase and a compound annual growth of return of 22.7%.

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On August 7th, Naga released their 2013 interim report and boosted revenue grew nearly 15% year-on-year to US$151.6 million, thanks to a burgeoning mass market segment and higher VIP margins. Naga is on par to crack the US$300 million bar. It’s important to note that revenues for 1H-2013 would have been higher if it wasn’t for the lower traffic due to the week-long official mourning period for the deceased former King of Cambodia at the beginning of the month and two several-day strikes by NagaWorld workers. With the return of normal business activity, higher tourisms, and the future opening of Naga2, revenues are expected to climb up. NagaWorld has some big projects in the pipeline that should lead higher results.

Margins

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Making money is great but margin is king. In this chart, we see that since 2006, the margins have been improving. NagaCorp was able to improve operating margins leading to net income growth. What’s impressive is that Naga was able to increase gross margin in a period of economic uncertainty and increasing competition. More interestingly, the latest interim report, 1H-2013, had the best margin on record (gross: 73.5%, EBITDA: 51.1%, Net: 41.5%). While the margins are expected to be sustainable, more frequent employee strikes might put negative pressure on the margin.

Accompanying these positive trends has been tremendous profitability. The graph below is pretty self-explanatory and significant. In 2006, Naga produced US$32.6 million in annual net income. By 2013, that number exploded to US$113 million. This is a great achievement and if 1H-2013 is any indicator I believe the trend will keep going. During the first six months of 2013, net profit increased by approximately 20% to US$62.9 million.

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Segments

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Source: NagaCorp company data

NagaCorp manages its businesses by segments, which comprise a mixture of business activities (casino, hotel and entertainment). The high profit margin of 73% are driven by the mass market segment. The mass market segment is the public floor gaming tables and electronic gaming machines (slots). At the end of June 30th, there was approximately 178 gaming tables and 1,450 slot machines in an area of 113,305 sq mt. Naga continues to increase the quantity of slot machines as this helps drive incremental business volume in the overall mass market as it frees up space for mid-end players at the tables. In other words, volume is increased with more middle bets at the tables and a lot more smaller bet size in the slot departments. During the period, Naga recorded a 20% increase in the mass market segment, in line with the increasing tourist arrivals to Cambodia (19% increase for the first five months of 2013). Of particular interest is the increase in visitation from China of 53%. If you ever get the chance, visit NagaWorld on your visit to Cambodia, NagaRock and Saigon Palace are two successful examples of the mass market segment.

It’s clear that the mass market segment has been carrying the charge for the last couple of years. NagaCorp’s VIP program has been pretty flat over the years. There is only one casino in Phnom Penh, and the minimum bet for both VIP and the mass-market segments are much lower than those of regional peers. Thus, NagaCorp is unlikely to attract the same customer base as does Macau/Singapore or create the same scale of operation. In order to place the Naga’s VIP market within competitive position within the region, Naga has successfully raised approximately US$156 million through a top-up placement (a little bit of dilution as a result). NagaCorp has started a revenue sharing program with its junkets where Naga receives 30% of wins and the junkets receive 70% of the GGR. About 80% of the junket rolling chip volume is currently under the revenue sharing program. In addition, five junkets have been signed up for the new VIP hall area where the maximum bet has been increased from US$24k to US$100k per hand. With a higher table limit, Naga is able to target a more aggressive VIP player which should lead to improved win rates. While paying 70% of the GGR to these junkets will lower Naga’s margins, management is confident that a significant increase in volumes will more than offset the lower margins. Since implementing the incentive program, the Naga’s management has observed an increase in better quality VIP players.

Dividend

NagaCorp’s dividend payout has been a major point of attraction towards the stock. Naga has a very high dividend payout – 67% average from 2006-2012 – and currently stands at 70%. At first, you might wonder if it’s sustainable because most of the time anything over a 50% payout ratio is pretty much on the chopping board.

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For the dividend investor the numbers above are on the right trend and since Naga doesn’t have a lot of capex, it looks like it is on track for a payout above US$80 million. NagaCorp has grown its respective earnings and dividend payouts at 30% and 45% CAGRs, 2008-12. Historically, the dividend yield has been between 5% and 7% but has dipped below 5% in the recent run up in the stock.

Positives

• Cambodia is a high growth tourist destination
• The Cambodia’s economy is growing at a high rate
• A 70-year casino license that will run till 2065
• A 41-year monopoly within a 200km radius of Phnom Penh that expires in 2035
• NagaCorp’s business appears to be relatively protected, with competition for its mass market competitors limited and a profitable VIP niche that will be expanded by the new suites and the Naga 2, to be completed in 2015, which will triple the number of tables at the casino, according to CIMB.
• Low tax rate through 2018: ~3% in 2013-compared to 39 percent in Macau.
• Increase in minimum table games bets, the total volume of wagers has increased.
• Zero debt, zero interest payment
• Low cost structure: Low operating and depreciation costs, favorable income tax rates and zero interest payments result in higher gross profit, EBITDA and net profit margins
• International tourist arrivals to Cambodia continued to significantly outpace worldwide tourism growth of 4% in 2012 and projected between 3% and 4% in 2013 by the United Nations World Tourism Organization, by recording an increase of 19% to approximately 1.8 million visitors in the first five months of 2013, compared to the same period in 2012.

Challenges

• A sluggish economic recovery, the ongoing European sovereign debt crisis, and a potential economic slowdown in China are dark clouds over the Indochina region.
• Highly dependent on foreign tourists’ appetite for gambling, especially Vietnamese and Chinese
• There is a surge in casino openings in Cambodia, mostly near the Thailand and Vietnam border. NagaCorp is also at risk of the success of border casinos near the Thailand and Vietnam border, and the Ho Tram in Vietnam. There’s also increased competition in the region, including Singapore, Malaysia and the Philippines where it will compete for the same VIP customers.
• Increased competition in the region. Singapore, the Philippines, and Macau.
• The risk that Vietnam will build its own casinos and allow locals to enter the property. However, so far, this risk has simply not materialized; despite pressure from such notables as Las Vegas Sands CEO Sheldon Adelson
• One of the risks facing NagaCorp is the rise of casinos in Cambodia and competition from those projects. To the company’s dismay, one of those competitors is, as IAG noted in December, currently one of its suppliers, US-listed Entertainment Gaming Asia. EGT’s agreement to provide slots to NagaWorld expires in 2016
• Gambling, in all its form, is illegal in Cambodia for the locals. However, it does not seem that the law is enforced. Many Cambodians are currently gambling at NagaWorld. NagaCorp’s profit includes income from the local Cambodians. It should be adjusted.
• Citi Research referred to NagaCorp’s high rollers as the “Poor Man’s VIP,” while CIMB Bank estimated that 70 percent of the casino’s VIP clients are “low- to middle-end players”, adding that NagaCorp “is not targeting the same types of ultra high-end VIP players that are being targeted in other markets,” probably referring to Macau and Singapore.
• NagaCorp recently issued 200 million shares (9.6% dilution) to expand VIP business.
• Gambling is a social “hazard.” Gambling is known to have negative effects on the quality of life of communities. Gambling generates poverty, prostitution, and crime, especially near the border.
• The more frequent labor strikes are giving NagaWorld a negative image. News outlets have reported that patrons have been complaining about the noises and the disruptions. Also an unsatisfied labor force might be less productive and might result in higher operating cost.
• The biggest infrastructure challenge Cambodia faces is the high cost of electric power and fuel. The country is increasing its power generation capacity rapidly and the supply of electricity is much more reliable than it was, but the continuing high cost of electricity is hurting the country’s competitiveness by undermining other advantages like the low cost of labor.
• There is a lack of high quality educated labor. More needs to be done to develop skilled labor.
• One of the country’s biggest needs is to build the capacity of public institutions, improving service delivery and good governance.
• NagaCorp is paying low taxes and the opposition is calling for a higher share of the profits. ~3% of NagaCorp’s net profit, or about $426,000 per month, was paid in taxes. The company is currently in discussion with the government to extend the tax agreement beyond 2018. If the tax rate returns to 20%, the value would be negatively impacted.
• Cambodia suffers from an image problem, grossly exaggerated by the international media (authoritarian government, corruption, human rights violation). The country also does not get the credit it deserves for the improvements it is making in people’s livelihoods and meeting the aspirations of most Cambodians.

Catalyst for growth

• If Naga could attract more Chinese, Thai, and Vietnamese gamblers, where it’s illegal to make bets in their homeland. Naga is not a Chinese centric business. Less than 10 percent of the revenue stream comes from Chinese customers. There’s room for growth since there is a large influx of Chinese tourists in Cambodia. With the 70% revenue split to junkets, management is aiming to entice sub-junkets in China to bring Chinese VIP players to NagaWorld. Of particular interest, visitors from China increased by 53% yoy, to 202,427 visitors in the first five months of 2013.
• More tourists. Cambodia is becoming a more mainstream destination. Over 5 million tourists are expected in 2015. Cambodia received 1.8 million visitors in the first five months of 2013, compared to the same period in 2012.
• The opening of Naga2 and NagaCity Walk is due in 2015. It will bring more gaming facilities, retail spaces, and hotel rooms.
• Indochina region is home to 240 million people plus tourists, NagaWorld is strategically located.
• IMF forecast the 6-year average GDP growth rate of countries within the Indochina region to range from 5.1% to 7.9% (from 2012 to 2017).
• A focus on the high margin mass market segment
• Problems in other countries – like sharply rising labor costs in China, increasing labor militancy in Indonesia, and safety concerns in Bangladesh – are likely to stimulate new investment and trade in Cambodia, particularly with Japan and Korea. Cambodian exports will also benefit from incentives given by major markets like the EU and the US that are not offered to most other Asian countries. This will help grow the Cambodia economy and indirectly benefit NagaCorp.

Risk Related to the Gaming Industry and NagaCorp

Frontier markets such as Cambodia where Naga operates are subject to greater risks than more developed markets, including legal, regulatory, economic and political risks. In addition, adverse political or economic developments in Cambodia or neighboring countries could have a significant negative impact on NagaCorp’s results. Cambodia is still a poor country, but it has made huge strides over the past decade in developing its economy, improving the quality of its institutions, and interfacing more with the rest of the world.

Labour disputes

Any labor disputes resulting in work stoppages and strikes could severely impede Naga’s operations. It might also pressure Naga to pay higher wages and benefits.

Political risk

The country is relatively stable but just went through a heated contested election in July. Cambodia has never witnessed peaceful transfer of power. The current government, led by Prime Minister Hun Sen, won the election with a smaller majority. The main opposition, portraying itself as the “party of the people,” is on the rise and is gaining ground among young voters. The opposition’s main position on gambling is not entirely clear, but it has been known to scrutinize the casino industry and wants a 50% tax of net profits of casinos.

Anti-Gambling law enforcement

NagaCorp’s profit includes receipts from the local Cambodians. Naga claims that 25% of its clientele are Cambodians with a valid passport. I am not sure how accurate that number is but I am a little bit of a skeptic. It’s illegal for Cambodians to gamble, but they are frequently seen gambling at NagaWorld or other casinos. It’s unknown what percentage of profits is attributed to local Cambodians but there is always the risk that the government might crack down.

Legalization of Gambling in Vietnam

What if Vietnam legalizes gambling for its own citizens? That would be an absolute game changer for NagaWorld. More than one-third of the company’s mass market customers come from Vietnam, often by bus from Ho Chi Minh City. The Vietnamese government outlaws gambling with the rational of protecting their citizens. The gambling ban backfires because it encourages gamblers to cross the border into Cambodia to enjoy the benefits (and Cambodia benefits too). There is no indication at the moment that Vietnam will overturn the ban, but there is a lot of pressure from billionaire casino builder Sheldon Adelson, who has plans to build a mega complex if the ban is overturned. Also, from the eyes of the Vietnamese government, higher gambling tax revenues does look attractive. Vietnam might think of adopting the Singapore solution; a US$80 fee for each citizen entering the premise. The reliance on profitable Vietnamese gamblers raises the risk that Vietnam will build its own casinos and allow locals to enter the property.

Demand for gaming services is unpredictable

Demand for gaming service is difficult to predict. The correlation between overall leisure and spending and spending on gaming appears to be non-linear. Demand for gambling services may be affected by the public opinion, negative and positive publicity and other factors. However, gambling is deeply entrenched in the Asian culture.

Change in the gaming regulatory environment may have a detrimental effect on NagaCorp’s revenues

Naga operates in a market which is subject to government supervision and regulation. Adverse change in the laws may have a material adverse effect on the business. In particular, new government restrictions relating to advertising, the size of casinos, and license issuing, along with higher compliance cost may have an adverse effect on profits.

Naga’s ability to operate in Cambodia may also be harmed by changes in the local laws and regulations, including those relating to gaming, taxation, environmental regulations, land use rights, property and other matters. For example, in February 2009, Cambodia’s Prime Minister called for the closure of the country’s sole bookmaker, Cambo Six, and all but two of the approximately 70 slot clubs in Cambodia’s Phnom Penh area, all of which had previously been licensed by the Cambodian government. This type of behavior carries a higher risk of uncertainty. It’s highly important that NagaWorld stays on the good terms with the government because of their unique monopoly agreement.

Increased competition from new locations and from Internet-based services

The government of Cambodia is open to granting a lot of new gaming licenses and to expand the industry. Neighboring countries are taking a similar position. Also Internet based gambling is expanding and becoming more and more accessible and can easily attract a large share of customers.

NagaWorld’s results are dependent on tourism

NagaWorld is dependent on the attractiveness of Cambodia and in particular Phnom Penh as a tourist destination. I don’t expect this risk to materialize soon since Cambodia is experimenting major growth in tourism each year and is becoming a more popular tourist destination.

Legal system

The legal system in Cambodia is still developing. There is a high degree of uncertainty as to how a dispute might be resolved in court and therefore a greater risk of unexpected outcome.

Weak Control Environment

Another downside risk is the perceived “weak” control environment in Cambodia, giving rise to money laundering concerns.

Valuation

There are no public pure-play operators in Cambodia. There is EGT that operates in Cambodia but its core business is providing slots and casino chips. Also EGT’s casinos are fairly small and at the startup phase. QueenCo leisure is also too small at the moment to compare. Naga is also very unique since it runs a monopoly operation. Historically, NagaCorp trades at a valuation discounts compared with Macau and Singapore names: including Galaxy, SJM, Wynn Macau, Sands China, MGM China and Genting Singapore. NagaCorp has the lowest P/E ratio among its regional peers even if its net margin and EBITDA margins (41% and 49% in 2012) surpass those of its Macau peers. Macau operators are trading at a 17.5x PE and Singapore at 22x PE. Naga is currently trading at 15x PE but has a 5-year average of 8.6X PE.

Source: Thomson Reuters Consensus Estimates

My US$1.07 target price for Naga reflects a sum-of-the-parts valuation. I used the earning power of NagaWorld assuming an average of the 15x P/E ratio and 10x EV/EBITDA (current average). Using this method, NagaWorld is worth ~US$2.3 billion. For my estimate of the NPV of Naga2, I assume 9x 2018E EV/EBITDA. Using this method, I arrived at an NPV of ~US$1.3 billion for Naga2. This far exceeds the $US369 million cost. I also included the fully-dilutive impact from the share issuance association with construction of Naga2. Please note that the dilution does not take place until the project is completed (end of 2015, early 2016). Using this approach I arrived at a value of $US3.9 billion for NagaCorp, or US$1.07 per fully diluted share. I believe that NagaCorp will achieve its price target based on strong tourism growth and a favorable monopoly environment.

* The estimates are from management guidance, Thomson Reuters and CITI Research.

Conclusion and Advice

Among the risks and challenges mentioned above, I see three main risks attached to this investment that would prevent the stock from reaching its target price, and all of them are outside NagaCorp’s control.

• The legalization of gambling in Vietnam. This is a very big “if” and is very unlikely. If you rely on the latest government comments, it will never happen. There is no way that Vietnamese will be allowed in a local casino. A lot of this speculation was generated when casino mogul Sheldon Adelson mentioned that he’s working on a plan to build a US$5-10 billion casino in Ho Chi Minh City and he will only do it if locals are allowed. The plan seems to fail since government officials reminded him and other casino operators that the law is the law; you either love Vietnam or leave it alone. However, the case for the legalization is a rationale one. You can’t control the emergence of online gambling, the proliferation of gambling joints, and the flow of your citizens forking over their money to NagaWorld and border casinos. The rational side tells you to control it and tax it. But when was the last time a government took a rational decision? In 2012, Vietnam’s Ministry of Finance had finished work on draft gaming legislation, copies of which have been distributed to the appropriate government departments plus industry stakeholders and experts for comment. Early version of the draft is not lifting the prohibition on local residents from accessing casinos but is toying with legalizing certain aspects (slots, sports). Further research was requested. The move might be partly inspired by Singapore’s success in reinventing itself as a casino hub in recent years and to grab a share of the massive revenues that go to illegal bookies and offshore websites.
• License Revoking: Never say never. The government did it in 2009 by closing 70 slot clubs in Cambodia’s Phnom Penh area, all of which had previously been licensed by the Cambodian government. Of course, none of these locations had the glamour and the size of NagaWorld. NagaWorld’s hotel and entertainment center actually help the image of Phnom Penh by offering a world class state of the art venue. NagaWorld needs to keep the government happy and part of it is giving them a new tower that is part upcoming Naga2 project.
• Higher taxes on profit. It will happen one day and maybe after 2018 when the current tax agreement expires. Tax rate on gambling is extremely low when compared to other comparable countries such as Macau (39%). The thirst for income and a growing call from the opposition might eventually lead to higher taxes one day. As already mentioned above, Naga is paying US$426.

Potential risk aside, the catalyst for growth are strong tourism growth in Cambodia, a favorable tax structure, strong demand for gaming, a monopoly environment, strong economic growth, an improved VIP segment, great management, a solid balance sheet and excellent financial performance.

Based on my valuation, the implied intrinsic value of NagaCorp is US$3.9 billion or US$1.07 per share. This represents a 20% increase from US$0.89 a share (does not include dividends), the closing price on August 9th 2013. The target share price represents a fully dilutive share count assuming the Naga2 transaction goes ahead in 2016.

Additional disclosure: Invest at your own risk. Please do your homework. Opinions are my own.