Crown Resorts: Interim result 2016

Similar to its 2015 result, there was a mixture of good, bad and ugly in Crown's 2016 interim result. Unsurprisingly weak earnings from Crown's 34% investment in Melco Crown Entertainment constituted the ugly part whereas the bad news was led by further delays in Crown Sydney, which is now due for completion in 2021.

A $15m or 34% increase in corporate costs was also disappointing, as was a deterioration in the company's investments in online gaming and Crown Aspinalls in the United Kingdom (although these are relatively immaterial). The market seems to be focusing on this bad news and overlooking the good: which is that Crown's casinos in Melbourne and Perth continue to chug along, with Perth doing so a little faster than Melbourne over the last six months, despite the continuing mining downturn, due to an 11% decline in VIP revenue and increased costs at Crown Melbourne.

All in all, then the result was pretty reasonable. Of greater concern is the potential cash flow hit from the amended assessments recently issued by the ATO, which total $362m in additional tax, interest and penalties (see Crown in income tax dispute). Unfortunately, Crown is guilty until proven innocent, in the sense that it'll likely have to pay at least some of the bill to stop further interest accruing at the usurious rate of 9.2%.

Despite its new 500-room hotel at Crown Perth being 70% complete, this added burden is unhelpful to say the least given Crown's still significant capital expenditure planned in coming years.

So whilst the delay in Crown Sydney will of course also postpone its contribution to earnings, any resulting delay in the bulk of the $2bn in capital expenditure on this project might actually prove helpful. In that vein, management is considering the cash flow impact of the amended assessments and the company will also continue to 'explore both capital markets and bank markets to finance anticipated growth projects'.

Melco special dividend

The US$120m (or AU$166m) special dividend from Melco Crown will also help. It would have helped even more had the entire amount been retained and used for capital expenditure or debt repayment – which we'd have preferred – rather than two-thirds of it being paid as a special dividend to Crown shareholders. (We'd also prefer less spending on the likes of Nobu but we can't have everything.)

In Betting on Crown – parts one and two, our base case assumed Crown would continue to receive ordinary dividends from Melco Crown in coming years. As such, with the bulk of its capital expenditure behind it now that Studio City Macau and City of Dreams Manila have opened, any additional cash that Melco returns to shareholders is a bonus. To that end, Melco Crown's board is currently reviewing its dividend policy.

Melco's ability to funnel more cash to Crown of course depends on how its Macau casinos – and to a lesser extent, City of Dreams Manila – perform. Despite the ongoing Chinese corruption crackdown and new casino openings (with more to open shortly), Macau's higher-margin mass market gaming revenue appears to have stabilised in recent months whereas the lower-margin VIP gaming revenue continues to decline. Whilst the latter stills affects Melco Crown, 90% of its earnings before interest, tax, depreciation and amortisation now come from the mass market punter.

The increased supply of hotels and gaming tables will take time to be absorbed by the market but, having helped create the downturn via their corruption crackdown and restrictions on visas and taking cash out of mainland China, the regulators seem to have moderated their tone recently. For instance, visa rules for mainland Chinese visitors have been relaxed and the proposed smoking ban in casinos has been deferred.

Despite the decline in gross gambling revenue, the number of visitors from mainland China has remained relatively stable at around 21 million each year. Further, as we noted in A Crown of thorns?, improved infrastructure, the diversification of both Macau and nearby Hengjing Island's economies into non-gaming activities and continued improvements in the average standard of living in mainland China all bode well for Macau over the longer term. 

In the short to medium term, less capital expenditure and increasing cash flow from Studio City and City of Dreams Manila as they ramp up will likely lead to improvements in Melco Crown's free cash flow, to the benefit of Crown as noted above.

Possible corporate activity

Elsewhere, we prefer not to speculate on possible transactions involving Crown and/or its investment in Melco Crown and will update members on any deals that are announced. 

We continue to believe that Crown remains undervalued but the ATO's potential windfall and the delay in Crown Sydney of course impact our valuation. As such, we're reducing our Buy and Sell prices by $1 each, to $13 and $19, to give us more margin of safety. BUY.

Note: The Intelligent Investor Growth Portfolio owns shares in Crown. You can find out about investing directly in Intelligent Investor and InvestSMART portfolios by clicking here.