Value Interview: Gabriel Castro, CFA

    Gabriel Castro, CFA is a fund manager at Singular Bank with vast experience in equity analysis, and portfolio management.

    Given the recent FBI investigation on Pax Global, how do you think this has affected the company’s reputation?

    At this point, it is difficult to state this with a high degree of certainty, but my preliminary due diligence indicates that the company has not been affected, or at least not as much as the share price suggests.

    Let me provide some context for the reader to support my statement. Yet, I would like to point out that I might give some misleading information myself as neither Pax management nor the FBI has spoken openly about the issue.

    On Tuesday, October 26, 2021, KrebsonSecurity reported that the FBI raided a warehouse in Florida from Pax Global Technology and carried out interviews with certain employees of Pax US. Krebs wrote that the FBI began investigating Pax after a major US payment processor started asking questions about unusual network packets originating from the company’s payment terminals. According to Kreb’s source, the payment processor found that Pax terminals were being used both as a malware “dropper” and as “command-and-control” locations for staging attacks and collecting information. The fact that Pax Global is a small Chinese firm and Krebs has a good reputation plummeted the stock by 43% and required Pax Global to apply for a trading halt until they could provide more clarity.

    A few days then, Pax issued a press release denying any wrongdoing, confirming that the group had not observed any material adverse change to its operations and business and claiming that only FIS/Worldpay (a US-based financial products and service provider and its UK affiliate) had discontinued their deployment of Pax terminals, however, it wasn’t significant as it only represented 0.25% of the total revenue of 2020.

    We understand that in early October FIS sent an email to Pax US asking a few technical questions about the operation of the smart POS and Pax US did not pay the expected attention but replied without sufficient detail -to Pax US’s credit I will say that they are growing at 70% per year and FIS is not a major client for them, so I guess they prioritized other matters at that time. In the end, FIS was not satisfied with those answers, and I assume they unilaterally communicated this to the FBI as they suspected security concerns.

    A few days later, Worldpay (FIS’s UK subsidiary) stopped deploying Pax terminals in the UK because they deemed the answers to be insufficiently detailed. At that point, Pax UK became aware of the problem and duly replied to FIS and Worldpay’s queries regarding PAX payment terminals. However, it was too late, as in the following days the FBI raided Pax US warehouse.

    Despite some generalist media thought that Pax terminals could be used to steal money, this statement is totally false as you should be aware that the Android element is separated from the payment processing element within a PCI & EMV certified PAX terminal, so the data that ‘flows’ through the payment processing engine of a PAX device never ‘flows’ through the Android operating system. Also, FIS/Worldline made a public statement that they had not found a security breach, so as far as I know today, the confusion lay in the geolocation feature and the use of dynamic IP addresses.

    What is Geolocation? It allows customers to pinpoint the location of their PAX device, similar to apps that allow users to find the location of their smartphones. It’s important to know that this is one-way communication: PAX device sends wireless network information to the geolocation service provider, but the geolocation service provider cannot communicate with the PAX device to obtain any other information on the terminal, so the claim about Pax terminals being used as a malware “dropper” and as “command-and-control” locations for staging attacks lacks credibility.

    What about dynamic IP? Be aware that many advanced Android-based services (not only Pax terminals) use dynamic IP addresses as do most IP-based services. Dynamic IP addresses can, and will, produce changing IP addresses at any given time. In all cases, however, PAX devices only connect to known servers through these dynamic IP addresses, and all payment data and all personal information are completely and securely separated, and firewalled, from such services.

    I understand the last words may be difficult to understand. To avoid technical details and summarize the problem to our reader, Pax’s servers are provided by Tencent, a Chinese multinational holding company of technology conglomerates, who resides in China. Although it was fully disclosed in Pax’s brochure, it created enough doubt to initiate an investigation. With all due respect, I don’t think the FBI would need much information to raid a Chinese warehouse knowing that important data and money are involved. Also, Krebs claimed that MI5 was conducting an intensive investigation at PAX, but it is strange as Pax reported no one from MI5 had talked to them and no warehouse/office was being raided in the UK. Assuming that Krebs’ statement is true, MI5 has taken a different approach rather than exposing Pax to the media without sufficient evidence.

    It’s been a long time and no one has been arrested or charged and Pax US has been operating as usual all along. I don’t expect the FBI to let Pax operate as usual if they perceive Pax to be a threat to the United States, do you? Also, a few weeks ago, Bloomberg reported some Treasury findings alleging that Pax has done no wrongdoing, but they were not comfortable knowing that Pax devices were sending data to third parties in China.

    At this point I tend to think that concerns about the security of Pax devices appear to be rooted in a misunderstanding of Pax Android-based technology, however, I like Pax’s reaction. The company has taken the right steps to ensure customer confidence and avoid brand damage. First, despite the geolocation service provider being fully compliant with all security protocols, if the customer feels more comfortable utilizing a geolocation service provider located outside of China, Pax Global is currently offering Amazon and Google as a provider starting from early November. Customers who remain concerned about geolocation know they can easily turn off the geolocation service through their PAXSTORE account. 

    Secondly, Pax tested their own terminals through different third-party companies and the conclusion was favorable as they confirmed without hesitation that there aren’t security risks in Pax products or services. Last but not least, Pax hired a third party to carry on an intensive investigation in order to prove Pax is fully compliant with the highest protocols and security standards.

    That being said, after this scandal Pax’s reputation might be damaged, but many important customers have already begun to express their confidence in the reliability and safety of Pax products after doing their own research. It is important to know that Pax is subjected to numerous safety tests before working with a new customer. Pax has joined many customers and products recently, so they have been rigorously tested by different companies around the world. In addition, our own conversations with people involved with the company in different geographies confirm that Pax is very busy with more orders than it has the capacity to handle. Moreover, in our last meeting Pax management confirmed that they have not changed their mind about plans to build a Smart Terminal industrial park to increase the production volume from 12 million units to 22 million units and improve supply chain management, so, at this point, we are cautiously optimistic and think that the company’s reputation hasn’t been damaged.

    Do you think investors’ confidence in the company and management will take some time to get back to what it was before?

    I guess the market needs some time to regain confidence, especially since most of Pax’s shareholders are in the United States. However, I believe that if Pax continues to buy back shares and, more importantly, demonstrates that the business has not been affected in the annual earning results, again strongly increasing the dividend and providing good guidance for 2022 as long as no more news from the FBI come out, market confidence will eventually come back.

    As I stated above, I strongly like Pax’s reaction. Pax issued a strong and detailed answer as soon as they could and set a conference call to answer shareholders’ questions. A typical Chinese company would have either remained silent or barely report. Also, they have been active on the market buying back shares and confirming their high confidence in their own fundamentals. While some people might argue that the buyback amount is not enough, I disagree, as I’m not sure if they are aware that they can’t buy back more than 5-6% of the current shares in any twelve-month period, as it would imply that Hi Sun (the major shareholders) would have to make a mandatory offer under Rule 26 of Takeover Code.

    Management’s alignment is unquestionable, not only because Hi Sun owns over 33% of the company while Pax management personally owns over 4%, but also because management has many stock options that could be exercised at any time after late 2019 and would provide an incredible profit as the strike is HKD 3.5. However, they have not executed them as they believe the stock price has not at this point recognized Pax’s amazing business.  

    From my experience, management has been kind to shareholders both by providing sufficient detail to assess the value of the company and by increasing the shareholder remuneration with buybacks and dividend increases from 8 cents in 2018 to 32 cents over the last twelve months. So, while it might take some time, I am confident that investor confidence will come back stronger than before.

    Do you think the market overreacted and that is the main reason that explains the sudden collapse in the stock price?

    Well, the market reaction was as expected, as the initial news suggested that the company was a Chinese government-led instrument to attack the U.S./Europe region. Of course, as a fund manager, I considered this scenario to be unlikely and the work we had done and our relationships with the company did not support this scenario. 

    Initially, we thought it was possible that Pax had been hacked, but after doing our due diligence, we quickly rejected this idea. I guess the fact that some time has since passed, Pax US is working as usual, and the FBI did not make any statements proves that we were right.

    I would say those are the main drivers for the stock soaring to the current HKD 6.3 from HKD 4.30 lows. At this point, I guess the market is focused on how big the impact has been on the business and several questions may arise, e.g., After growing at 30% CAGR over the last years, is Pax going to decelerate or even decrease? How many clients are leaving? How many clients were considering working with Pax before the scandal and decided not to join them after it?

    At this point, our due diligence suggests that Pax’s business has not been impacted and customers continue to order Pax products as they are aware that Pax has the best product among its competitors. I can confirm that we have been buying over the last few days and we now own many more shares than before the scandal. 

    Our confidence in Pax’s fundamentals remains high and today we can buy a growing business at a deep value price. We expect Pax to report over HKD 1 EPS and to have almost HKD 4 in cash by the end of the year, contrasting very well with the HKD 6.3 at which the stock is trading and offering limited downside. Moreover, we expect Pax will continue to outperform the market that is expected to grow 19% CAGR by 2025 according to Counterpoint research.

    Keep in mind this is not a recommendation and I encourage to carry out your own analysis.

    There are just a handful of companies that can be compared with Nagacorp in terms of competitive advantages. The valuation is still very attractive at these levels. Why do you think the market is attributing a low valuation to the company? Is it the poor results over the recent past or do you think it has to do with the risks associated with the region? 

    Definitely, it’s difficult to find a company with Nagacorp’s moat with an aligned and excellent management team trading so cheaply. I would say that there are other companies with monopolistic entry barriers like Nagacorp, but they are usually run by the state for its own benefit, e.g., Gazprom, and they don’t take shareholders into consideration at all.

    Nagacorp is a casino with unique competitive advantages such as a monopolistic license -expiring in 2045 and preventing competition in a radius of 200km from Phnom Penh (the capital of Cambodia)-, an amazing location, low-cost player, and low-tax country. These unique features are the reason for the astonishing capital returns.

    The company has an excellent management team, whose Chairman, Timothy Patrick McNally, has served the FBI for more than 25 years, being a specialized agent in Anti-Corruption, and Anti-Money Laundering. Consequently, the risk of money laundering that is inherent to a casino is mitigated. In addition, Dr. Chen Lip Keong, CEO/founder and currently owns 70%, is fully aligned with the shareholders and now actively buying shares on the open market. Add to this mix the company’s friendly dividend policy (Nagacorp has distributed $1.5B in dividends out of a total net profit of $2.3B since the IPO in 2006), and you have a compelling investment.

    I believe the market is more disturbed by the Asian zero tolerance for Covid than before. While the US and Europe have fully reopened, Asia has implemented a stricter policy and I don’t expect to see fluid traffic from China to other parts of the world until at least the end of 2022. But this zero-tolerance not only extends to China, for example, Nagacorp casino has also been closed since the end of February and has not reopened until mid-September. Nevertheless, Cambodia has managed Covid’s crisis very well and is now reopening for tourism, which should have a positive impact on Nagacorp’s business.

    Those concerns about Covid tolerance are reflected in the stock price. Nagacorp was trading above HKD 14 before Covid. In 2020, the stock fell to HKD 7.5 but the recovery was quite fast (in line with the business as soon as it reopened despite China being closed) soaring to HKD 11 before the casino closed in late February 2021. Now that the casino is open, I would say the money will jump in again as soon as Nagacorp releases results and resets the dividend showing the resilience of the business. 

    Another issue that may be impacting the stock is Macao’s valuation. Most of Macao peers (Wynn Macau, Sands China, MGM China Holdings, etc.) are heavily down mostly because of Macao’s gaming law revision and lack of news regarding concession’s renewal (most licenses expire by mid-2022). Although the new regulations seem not to affect the business, it definitely worsens corporate governance with measures such as the presence of government representatives on the board companies of Macau casinos, dividend limitations, to name but a few. Despite it doesn’t directly affect Nagacorp, ETF and comparable valuation may have impacted Nagacorp’s share price in the short term

    I think all of this is temporary and we will see a stock rerating driven by the recovery of the business.

    Do you think investors, in general, overestimate the risks of investing in emerging markets?

    I think there are many emerging markets that are very different from each other, so we should analyze them one by one. Generally, people think that there is more fraud in emerging markets because the regulation is weaker. I will not say the opposite, but the same happens in developed markets with cases like Wirecard in Germany or Gowex in Spain. I believe the investor needs to open his mind and do proper work to avoid this kind of fake companies no matter the geography.

    Considering globalization could we see inflows into emerging markets surge over this decade?

    I believe that any investor who avoids emerging markets will have difficulties generating decent returns in the coming years. Emerging markets will drive global growth over the next decade and, in general, culture is improving. I would say that the reason most emerging markets haven’t performed so well is the lack of communication among companies and the non-existent capital allocation. 

     

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