A savage day for Tatts and Tabcorp

One wonders whether the Victorian Government had any inkling when it announced it had "formed a view" that Tabcorp and Tatts Group weren't entitled to compensation when their gaming licences expire in 2012 that it would instantly wipe $3 billion off their market capitalisations.

The market response to the Government's new gambling policy – but more particularly its decision to contest Tabcorp and Tatts' entitlement to a $1.3 billion reimbursement of their existing licence fees – was savage. Tabcorp lost 20 per cent of its market value after trading resumed and Tatts 30 per cent.

The extent of the damage done to their shareholders means that Tabcorp and Tatts will be even more determined than they already were to challenge the government's "view" in the courts. It probably also ensures that the class action lawyers and litigation financiers will already be opening files on the matter – $3 billion provides a lot of incentive.

Until Thursday, the market, along with the companies and almost everyone except the Victorian Government, believed that if Tabcorp and Tatts failed to retain their gaming licences in the post-2012 environment they would be compensated in accordance with the terms of their contractual relationship with the Government, which in Tabcorp's case dates back to its float in 1994.

The Government is relying on a very technical interpretation of the contracts, under which the companies must have their original licence fees returned or be paid the price paid by the purchaser of the licence, whichever is the lesser. It appears to be arguing that under the new regime, where individual pubs and clubs will bid for gaming machine "entitlements", there is no new licence and therefore no compensation required.

Whether that holds up in a court or not, the decision to try to walk away from the clear intent of the original agreements – that the companies would be reimbursed if they weren't able to renew their licences – is going to damage Victoria's reputation.

The cost of private sector contributions to public-private partnerships – and the number of lawyers hired to pore over the fine print – may just have risen sharply because the Government has broadcast a sobering signal of sovereign and regulatory risk in dealing with the state.

The sharemarket reaction looks, at first glance, like an over-reaction, given that the loss of value was more than twice the $1.3 billion at stake.

With Tatts now destined to lose about 40 per cent of its earnings base and Tabcorp about 25 per cent, however, the certainty that they won't be able to renew their licences and the question-marks that places around their business models and strategies was always going to magnify the impact on their share prices.

They are also going to have to write off the value of those licences – whether over the remaining four years of the current licences or immediately. That has balance sheet impacts, could affect their cost of debt and may impact on their ability to maintain dividend payments in future.

It is fortunate that both companies had been stockpiling capital in (the mistaken) anticipation of paying big cheques to renew their licences – they both have very conservative balance sheets – or the Government's announcement could have had catastrophic effects.

The knowledge that they will lose their gaming business from 2012 isn't in itself a massive shock – it was always a possibility, although the incumbents would have had significant advantages had the Government chosen to simply re-tender them. With a pre-existing large investment in infrastructure and expertise, the licences would have been worth more to Tabcorp and Tatts than anyone else.

There shouldn't, however, have been a lot of sharemarket value attributed to licence retentions. In a competitive tender the companies would effectively have had to bid something close to the full net present value of the cash flows over the new licence period. There might have been some value attributed to the advantages of incumbency but it shouldn't have been very significant.

The more significant issue would have been the reimbursements. While they might total "only" $1.3 billion – about $687 million in 2012 dollars for Tabcorp and $598 million for Tatts – there should have been an opportunity to invest that capital and generate earnings streams to offset the loss of gaming earnings.

It is the actual loss of capital and opportunity, as well as the huge holes torn in their business models and the uncertainty that has generated, that will have driven the brutal market response.