Share Investor: Morningstar Revalues Sky City Entertainment Group II

A bizarre combination of a fast buck coupled with a faster mood to spend it, the latest missive - out yesterday - by Morningstar has me in stitches.

$4.70 Undervalued but there is time to purchase

Undervalued but there is time to purchase

A transformative deal that will underpin casino earnings Investment rating SKC offers gaming services at its casinos in NZ and Australia. The entertainment complex in Auckland is the major driver of earnings accounting for 60% of its operating profit. SKC faces little competition due to NZ government's blanket ban on new casino licenses. This has allowed the company to operate at very healthy profit margins and generate abundant cash flows. Earnings will pick up next year following the Rugby World Cup in 2011. Judicious investments are being considered to lift growth in the longer term.

SKC will invest AUD 350 million in expanding its casino operations in Adelaide after reaching an agreement with the South Australian government.

The deal includes an extension to the current gaming exclusivity, an increase in the number of machines and tables, lower taxes on VIP gaming and the approval to introduce cashless gaming.

The revised regulatory framework is subject to legislation and approval from the Independent Gaming Authority but we are fairly certain that the legislation will favour SKC.

Impact

We forecast Adelaide’s EBITDA to increase by AUD 62 million on an incremental basis by FY18, implying a post tax return on investment of 10.5% which will rise to 18.3% by 2022.

Our FY14 and FY15 projections increase by 1% and 2% respectively reflecting the addition of VIP electronic gaming machines. The real kicker from the expansion comes in FY18.

Since the entire cost of the expansion will be financed by debt we expect the company’s gearing measured by debt to EBITDA to rise from 2.3 times in FY12 to 2.4 times in FY16 before trending downwards. This is within the company’s banking covenants of 2.7 times.

Recommendation impact (last updated: 23/01/2013)

We are increasing our valuation to NZD 4.70 per share mainly driven by Adelaide’s expansion and the roll-forward of our earnings model. Consequently the stock appears undervalued compared to our intrinsic value.

Event analysis

A deal that is likely to transform the Adelaide casino
SKC will invest AUD 350 million in expanding its casino operations in Adelaide after reaching an agreement with the South Australian government. The regulatory relief obtained from the government, involving increased gaming product and lower VIP taxes, is likely to significantly enhance the competitive position of the Adelaide casino and dramatically lift earnings over time. We forecast Adelaide’s EBITDA to increase by AUD 62 million on an incremental basis by FY18, implying a post tax return on investment of 10.5% which will rise to 18.3% by 2022. Our FY14 and FY15 projections increase by 1% and 2% respectively reflecting the addition of VIP electronic gaming machines. The real kicker from the expansion comes in FY18.

Overall, the casino redevelopment will add NZ50 cps to the company’s intrinsic value. We are increasing our valuation to NZD 4.70 per share mainly driven by Adelaide’s expansion and the roll-forward of our earnings model. Consequently the stock appears undervalued compared to our intrinsic value. We expect a further uplift in valuation to the tune of NZ70 cps should the company bag the impending National Convention Centre (NCC) project in Auckland. SKC has been selected as the preferred developer and stands a good chance of building the NCC. This will provide another catalyst to SKC’s share price.

Highlights of the deal.

SKC entered into an agreement with the South Australian government regarding the future operating, regulatory and taxation environment for the Adelaide Casino. The highlights of the deal are:

1. An extension to the current license exclusivity from June 2015 to June 2035. This provides certainty and will be viewed positively by the company’s bankers.

2. Increase in the number of electronic gaming machines (EGM) from 995 to 1500 and table games from 90 to 200. This includes new gaming products like automated table game terminals. We understand around 200 new machines will be rolled out by the end of 2014 while the remainder will be rolled out between 2015 and 2016.

3. New taxation regime for VIP and non-VIP EGMs and table games. The deal delivers a significant reduction in EGM taxes from 35% to 10.9%, which should propel EGM revenues. This will to some extent be offset by a rise in table gaming taxes from 34.4% to a maximum of 41%. VIP taxes on tables will remain at 0.9%.

4. Approval to install card-based cashless gaming for all EGMs and table games and ticket-in ticket-out in premium VIP gaming areas. This should augur well for the casino as the current regime of using coins was becoming a big hindrance, and was hampering activity.

The revised regulatory framework is subject to legislation and approval from the Independent Gaming Authority but we are fairly certain that the legislation will favour SKC. Once enacted, the regulatory changes will come into effect from 1 July 2013

Expansion to be done on a staggered basis with real growth kicking in from FY18
The expansion of the Adelaide casino includes the construction of a six-star boutique hotel, celebrity and signature restaurants, new carpark facilities and the creation of international VIP gaming suites and salons similar to the Horizon VIP suite in Auckland.The total cost of the project is estimated to be AUD 350 million spread over three years from FY14 to FY16. The amount includes AUD 20 million to the state government and capitalized interest. We understand the initial expansion in FY14 will involve reconfiguring the current gaming floor to accommodate approximately 200 EGM’s. Following that, a new building will be built to accommodate an additional 305 EGM’s and 110 tables. This is expected to be completed by the end of FY16. The car park will be rolled out in FY15 while the hotel (consisting of 150 rooms) and new restaurants will be completed in FY16. We therefore believe the full benefits of the expansion will only be visible after FY16/FY17 and have modelled for a significant jump in revenues in FY18.

A higher proportion of premium VIP offerings and cashless gaming will boost unit revenues

The addition of new gaming machines and tables will dramatically change the revenue mix in favour of premium VIP customers. We expect all the new EGM’s and approximately 70% of the new tables to be dedicated to VIP players. The vast majority of VIP tables will be designated for domestic customers with some for international VIP players. SKC sees a large opportunity from interstate and premium local players – a market that remains relatively untapped at the moment. We believe the VIP players have shunned the casino so far because of its archaic coin based system, higher taxes on EGM’s and the lack of restaurants and bars. Similarly, the construction of the international VIP suite will entice more international players to Adelaide over time. The success of the Horizon VIP suite in Auckland gives us confidence that SKC could ultimately achieve a similar turnover in Adelaide. We anticipate marketing expenses to increase as the company tries to woo both domestic and international VIP players to Adelaide but we expect the company to earn a good return on this investment.

We assume that new EGM’s deliver unit revenues of AUD 490/day while existing EGM’s deliver unit revenues of AUD 350/day in FY18. This compares with current unit revenues of AUD 180/day. The significant uplift will be mainly driven by the move to cashless transactions and new product. Also, the new EGM’s will benefit from premium VIP players who arguably spend more than mass market EGM’s. After factoring in the effect of dilution from new machines because of lower initial utilization rates (which will improve as traffic increases) we expect the overall unit revenue per EGM to be approximately AUD 275 per day which would still be well below Auckland’s current revenue of NZD 390/day and Melbourne’s current revenue of AUD 500/day. Similarly in the case of table games we anticipate average unit revenue to be AUD 2700/day for existing tables and AUD 3390/day for new tables with the latter benefiting from a higher mix of premium VIP players.

The company’s international VIP suite will be modelled on the lines of Auckland’s Horizon suite with approximately 16 tables. Horizon has been a big success for SKC in Auckland and was instrumental in boosting VIP revenues from NZD 26 million in FY11 to NZD 51 million in FY12 on a turnover of close to NZD 4bn. We anticipate Adelaide’s VIP turnover to be approximately AUD 3b in FY18 and revenues to be AUD 41 million assuming a theoretical win rate of 1.35%.

Utilization will be low to start with but will increase with higher foot traffic
In FY18 we expect 25% of the new EGM’s and tables to be utilized. This will progressively increase as traffic to the casino rises overtime. In this respect we think the investment currently being made by the South Australian government in beefing up Adelaide’s infrastructure could potentially boost tourists to the city, which will augur well for SKC as well. We understand the state government is spending AUD 920 million in redeveloping the Adelaide cricket stadium, building a convention centre and constructing a footbridge (over the Torrens river) connecting the city centre to the Adelaide stadium. The Adelaide stadium will have a capacity of 50,000 and will host AFL games as well. The stadium is expected to be completed by March 2014 and the convention centre will also be completed around the same time. The casino will be attractively located in close proximity to the footbridge and the convention centre and should be able to capitalize on visitors coming through to the stadium as well as the convention centre. We also think that the creation of 2,000 parking lots will help drive higher casino visitations.

EBITDA expected to more than double on lower VIP taxes

The impact of lower taxes will be mainly felt on new machines and tables as they will predominantly cater to VIP players. The EGM tax rate for VIP players will reduce from 34.4% to 10.9% whilst they will remain at 0.9% for tables. Taxes on mass market EGM’s will go up from 34.4% to a maximum of 41% and tables from 0.9% to 3.4%. Consequently EBITDA margins on new EGM’s in particular will be significantly higher while margins on existing EGM’s and tables will reduce slightly because of higher taxes. Based on our aforementioned revenue projections we forecast incremental gaming EBITDA of AUD 57 million in FY18. We expect non gaming businesses such as the hotel, car park and restaurants to generate AUD 5 million in incremental EBITDA in FY18. After factoring in depreciation and interest costs we expect the expansion to contribute AUD 23 million to the company’s bottom line. In the near term (FY15) we expect the addition of 200 VIP EGM’s and higher revenues from existing machines (due to cashless gaming) to increase EBITDA by around 2%.

Reasonable uplift in valuation, traffic growth remains the key

Based on our forecast of AUD 62 million in incremental EBITDA, the project will deliver an after tax return of 10.5% on an investment outlay of AUD 350 million. This should add NZ50cps to SKC’s valuation. The after tax return will rise further with increased traffic and higher utilization of new gaming facilities. Clearly SKC will need to market the casino to would-be VIP players both domestically and abroad. However failure to achieve growth in visitors would affect utilization rates and project returns. This would have a negative impact on the company’s valuation and share price.

Gearing unlikely to breach banking covenants even if National Convention Centre materializes

Since the entire cost of the expansion will be financed by debt we expect the company’s gearing measured by debt to EBITDA to rise from 2.3 times in FY12 to 2.4 times in FY16 before trending downwards. This is within the company’s banking covenants of 2.7 times. We also expect SKC to generate solid operating cash flows and maintain dividends at the current payout rate of between 60-70%.

We think SKC’s balance sheet might be stretched should it be awarded the NZD 350 million National Convention Centre project in Auckland. On our estimates gearing could exceed 2.7 times implying the need for an equity raising to help with the funding. However the company will start generating cash flows from regulatory concessions upfront (as a result of additional EGM’s and tables in Auckland) before committing funds to the project and therefore could get away from raising equity. We will get more clarity once the deal materializes.

c Share Investor 2013

Share Investor

Thursday, January 24, 2013

Morningstar Revalues Sky City Entertainment Group II

Impact

Event analysis

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