Echo: no longer a star?
The company's theoretical win rate on VIP revenue may be too high.
Echo Entertainment (ASX: EGP) shares have doubled over the past two years, with shareholders also receiving 19 cents in fully franked dividends over this period.
Intelligent Investor upgraded Echo to Buy in September 2013 (see Echo is worth a shout) before downgrading to Sell in November 2014. The company's rising share price since then suggests we sold too soon but, even so, members who followed our recommendations would have received a total return of 53% in little more than a year.
Having greatly improved its results from both VIPs and ordinary punters in recent years – particularly at its flagship The Star casino in Sydney – Echo now seems fairly valued and so we don't see a margin of safety at current prices.
One issue in particular that many investors seem to be overlooking is how Echo accounts for revenue from VIPs compared to competitors Crown Resorts (ASX: CWN) and Sky City Entertainment Group (NZX: SKC).
Due to the large amounts VIPs bet, revenue from them is volatile depending on whether luck favours them or the house. This can unduly influence casinos' earnings over the short term and so they report two sets of results: actual results based on the actual win rate from VIPs and 'normalised results', which are their actual results adjusted for the theoretical win rate (or the amount of money the casinos would expect to win from VIPs over the long term as a result of the house advantage).
Crown and Sky City both use a theoretical win rate of 1.35% - an industry standard based on the house advantage in baccarat, the game of choice for VIPs – whereas Echo uses 1.43%. Echo calculates this figure based on its average actual win rates over the previous five and seven years.
Echo's actual win rates in 2014 and 2015 were 1.32% and 1.27% respectively, below the 1.43% theoretical win rate and, importantly, achieved on significantly larger VIP turnover than in earlier years. As a result, Echo reduced its theoretical win rate from 1.62% to 1.43% in 2015 but this rate is still 0.08% higher than where it probably should be.
This seemingly small difference has a material impact when applied to the $46bn in VIP turnover in 2015 (see Table 1). Adjusting for a 1.35% win rate, you can see that Echo's normalised EBITDA declines by $33m or 6% and its normalised NPAT by $23m or 11%. These differences flow through to a higher EV/ EBITDA multiple and PER.
|Normalised 2015 (as reported)||Normalised 2015 (adjusted)||Difference (%)|
|Theoretical win rate (%)||1.43||1.35||-0.08|
|* Based on Echo's share price of $4.85 on 13 Nov 15|
Management will continue to review Echo's theoretical win rate and we wouldn't be surprised if the company does in fact lower its theoretical win rate in coming years if current trends continue (its actual win rate for the four months to 31 Oct 15 was 1.0%).
If and when it does, investors will need to adjust their expectations, not only leading to lower estimated EBITDA and NPAT but also likely leading to a reduction in multiples that investors are willing to pay for Echo.
This is one of the reasons why we currently prefer Crown over Echo.
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