Description

Universal's core business is the manufacture and sale of Pachinko machines in Japan as well as slot machines.  Pachinko is a Japanese gambling game that has been around for years.  Universal also is the largest shareholder of Wynn Resorts Limited (ticker: Wynn) with a 20% stake in Wynn.  Universal's largest shareholder is it chairman, Kazuo Okada, who owns about 68% of Universal.  Chairman Okada also sits on the Wynn Board of Directors.  There is no analyst coverage despite the company having a market capitalization of approximately $1.8 billion US dollars.  What originally attracted us to this idea was that it was a compelling sum-of-the-parts story with a couple of interesting and imminent catalysts.  That is,  if one took the value of Wynn shares held by Universal plus the cash on its balance sheet, you would have a value that was greater than the market capitalization of Universal.  Essentially, you would get the business and any future projects for free (actually, the implied value was negative).   Its core Pachinko business should generate EBITDA in excess of $350 million this year and will generate meaningful free cash flow so it is hard to see why this should have had a negative value.  While the value was there, we had no view on whether the Wynn stake would ever be monetized.  The discount was significant enough that we felt our risk-reward afforded us a substantial margin of safety.  Additionally, the company repurchased about 6% of its stock back in December, a rarity for Japanese companies.  It should be noted that, at the current stock price, the company's dividend equates to a 5.3% yield, augmenting shareholder returns over time.   With the stock trading at a price earnings multiple of around 5.0x 2012 and its sum-of-the-parts value, there is a real margin of safety in owning the stock. 

The catalysts that we identified at the time of our investment as having the potential to unlock substantial value were:

            1.  The company received a gaming license in the Philippines and is constructing a large casino there-- it has guided 2014 casino revenues to be approximately $2 billion (with a likely 40% ebitda margin or higher this would mean an incremental $800 million of EBITDA in 2014); and

            2.   The Japanese government is currently considering the legalization of gaming in Japan, which would be a significant benefit for Universal both in terms of equipment sales as well as being a likely party to secure casino construction and operation rights if the legislation were to pass.

Then something very strange and interesting happened.   Chairman Okada, as a board member of Wynn, had been inquiring into Wynn's use of certain funds in the past including contributions it made to Macau University. Wynn, obviously not happy about the scrutiny, turned around and invoked an obscure clause in the companies by-laws to deem Okada/Universal to be an "unsuitable person" by reason that it violated the Corrupt Foreign Practices Act and, acting in accordance with that provision of its by-laws, Wynn decided to redeem Universal's shares at a 30% discount to the value of the stock.   This was based upon findings that Universal spent $110k over a number of years flying Philippine regulators to Wynn Macau and providing them lodging etc.  to show them the type of casino that Universal would build in the Philippines.  These expenses seem reasonable with a valid business purpose.  Also, one could argue that this is a de minimis amount over a number of years.  In fact, Sheldon Adelson and the heads of other gaming companies publicly supported this practice and found nothing wrong with Universal's actions, based on the facts that Wynn set forth. 

For starters, the price proposed, a 30% discount to the Wynn stock price, does not seem fair and does not seem to comply with the fair value standard set forth in the "unsuitable" clause in the by-laws.   The discount (allegedly because a portion of Universal's Wynn shares could not be freely sold) seems arbitrary and completely unreasonable.  This is especially true if one looks at the present value of what Universal receives which is a ten year note w/ a bullet payment at 2% interest.  Thus, on a present value basis, the actual  value to be received by Universal is much lower that the amount with the discount.  The actual discount would be in excess of 50%.  It is going to be quite a challenge for Wynn's attorneys to argue that this is fair compensation.

This is a unique event, where a US company is actually making a determination of federal law--depriving Universal of any sort of due process.  Okada is a billionaire and will use all necessary resources to protect the interests of Universal.  It seems likely that, whether or not the share redemption can or will be reversed, the price that Universal is set to receive under the Wynn structure will almost have to be significantly increased.  Ironically, the major catalyst, the timing of which we had no feel for, could possibly have just happened.  Now we have to wait for the litigation process to run its course and we will likely have our catalyst.  

I would argue strongly that Universal is trading at a steep discount to its intrinsic value, even if the Wynn actions were to be deemed legitimate, including Wynn's draconian payment proposal.  The present value of the Wynn payments over time and just the cash on the balance sheet equals the current market capitalization of the stock.  Putting a low multiple on the Pachinko business would provide excess value that would provide a minimal return of 66% over the current trading price of Universal.  Below, I provide a breakdown of three different cases and the possible returns on the stock. 

It should be noted that we do not include any value for the casino in the Philippines, which is scheduled to open in 2014 and which is fully supported by the Government of the Philippines which will be investing in substantial infrastructure around the new casino to insure the best chance for success.  Additionally, we do not include any value for Japan's potential legalization of gaming this year or in the near future (we do think this is likely).  Either of these catalysts should have a significant positive impact on the price of Universal stock.  With just the Philippines factored into the equation, we can get to additional value equal to at least 100% of the market cap of Universal if not much more.  Again, this is NOT included in our spreadsheet below.  Japan would be even more substantial, but the value is obviously hard to handicap at this time.

Accordingly, Universal is a compelling sum-of-the-parts investment with reasonably near term catalysts and a substantial margin of safety.  See below:

Catalyst