Echo is worth a shout

It’s on. James Packer’s plan to build a towering new VIP-only casino on the edge of Sydney Harbour has been all but approved. For Echo Entertainment, owner of Sydney’s current monopoly casino, The Star, it’s all over, right?

When the new Crown Sydney opens its doors, international VIP gamblers and locals alike will flock to its glittering charms, leaving The Star to fade into irrelevance on the other side of Darling Harbour. Revenue will fall. Profits will collapse and dividends will be canned.

That certainly seems to be the market’s verdict. Echo shares have fallen 11% since the announcement and hover around record lows. But, as Nathan Bell recently highlighted, when investors become fixated on a 'well-known fact', it can lead to mispricings and investment opportunities. As former Intel chief Andy Grove said, quoting Alois Schmidt, his professor at City College of New York: ‘When everybody knows that something is so, it means that nobody knows nothin'.’

Echo will no doubt be affected – that much is clear – but the important question is: ‘by how much?’ Let’s start at the bottom of the barrel by pondering how bad it could get.

The key point to consider here is that beyond The Star, Echo also owns three properties in Queensland: Treasury Brisbane, Jupiter's Gold Coast and Jupiter's Townsville, which make up around a third of the company’s earnings. Here, the effects of a new VIP-only operation in Sydney will be limited. Less than 15% of these casinos’ revenue comes from VIP business, with the focus instead being on pokies and table games for the average punter.

Bread and butter

Even in Sydney, Crown’s new casino will have a limited impact. To start with at least, Crown will be restricted to operating as an invitation-only members’ casino. How this will work in practice is not entirely clear, although it’s unlikely to rival the Australian Club for exclusivity.

Even so, Crown Sydney will have no pokies and invitations and high minimum stakes will be offputting to the average punter. As a result, The Star’s bread and butter – its 1500-odd pokies and its low-stakes table and electronic games – are not directly under threat. Between them, these activities make up about 50% of The Star’s revenue.

Of course, the VIP business – which makes up 40% of The Star’s revenue – is directly in Crown’s firing line. A new VIP-only casino is likely to win a good half of this business or force Echo to offer VIPs more incentives reducing margins.

Crown Sydney is also likely to affect the non-gaming portion of The Star’s revenues – the hotels, restaurants, bars and spa – as fewer high rollers splash their cash on glitzy suites. These revenues contribute about 10% of The Star’s revenues and we’d estimate that they could fall by around 10-15%.

Putting it all together, Crown Sydney could slice about 20% off The Star’s revenue, or about 13% of overall group revenue. Given the relatively high fixed costs, on things like property maintenance and advertising, the effect on profits would be greater, perhaps knocking earnings before interest, tax, depreciation and amortisation (EBITDA) down by about 25%, from $391m to about $300m.

Spruced up Star

If we assumed that happened today, and placing Echo on EBITDA to enterprise (net debt plus equity) multiple of eight gives us an enterprise value of $2,400m. Once adjusting for net debt of $707m, you get an equity value of $1,693m, or $2.05 per share, about 25% below the current share price. That’s hardly a disaster. It’s also completely unrealistic, because there are six years between now and when Crown Sydney will open, and with Echo having just spent $870m sprucing up The Star, profits are likely to grow considerably between now and then.

In Table 1 we’ve set out some more realistic, but still bearish assumptions about how the business might perform up to 2019 and in the year after. We’ll admit these assumptions are rubbery, but they do at least help us put the current share price into context.

Starting at The Star, given the relative resilience of casino earnings and the recent refurbishment, we’ve assumed that pokies, electronic games and table games grow in line with the economy – at about 3% a year – until 2019, and then flatten off as the indirect effects from Crown Sydney take their toll.

For the international VIP business, we’ve assumed revenues will increase about 20% in the current year (the first full year after the refurbishment), tapering back to economic growth towards 2019, before it promptly halves in 2020. For the non-gaming business we’ve assumed growth in line with the economy until 2019, followed by a drop of 10%.

Realistic bear case

Over the border we’ve assumed slightly lower growth rates due to the age of the assets and likely slowing of the Queensland economy, and a more muted impact from Crown Sydney in winning VIP business.

Totting it all up, this more realistic bear case sees revenue rising by a total of around 25% before 2019, before it falls around 20% in 2020, and EBITDA rising from today’s $391m to about $545m in 2019 before falling back to today’s levels in 2020.

After accounting for maintenance capital expenditure, interest (on Echo’s modest $700m of net debt) and tax, discounting the remaining free cash flows at 10% we arrive at a value per share of around $2.65 – not far from the current share price.

It could get worse. VIP earnings could suffer a bigger hit from Crown Sydney, and the other parts of the business might fail to grow. In that case the value of the business is likely to be lower, but even in these scenarios it’s hard to imagine a value of less than the $1.50 per share.

Margin boost

So what about the upside? Enter John Redmond, the new chief executive charged with ensuring our more dire predictions are proved wrong. He has extensive operational experience, having run casinos for MGM Grand for over a decade.

He’s already negotiated a more favourable deal on wages (which make up 40% of costs) and is tweaking which tables are open and when which should help boost average revenue per table/machine. Small wins here could help boost EBITDA margins which trail Crown by nearly 7%, at around 21%.

Marketing is also a focus. Rather than splashing millions on flying over Hollywood stars such as Leonardo DiCaprio and Jamie Foxx for parties they don’t even attend, he’s creating a new smarter loyalty program that will help keep locals coming back to the casino and gambling.

Early signs are promising: non-gaming revenues at The Star rose 27% in 2013. The challenge now is to convince guests that have headed over for a nice meal to also drop a few dollars on the tables. And it’s not like you have to convince Sydneysiders to gamble – there’s more than three times The Star’s existing pokies business being conducted within two kilometres of the building.

Combined, these initiates could help lift revenue growth for pokies, table and non-gaming revenue above 3% a year whilst also reducing costs.

Increasing the pie

Redmond also has designs on the VIP business. Since its refurbishment, The Star has doubled its VIP business and there’s potential to do it again. And with six years to butter up potential clients, perhaps it’ll be able to hold onto more than half of them. There’s even a chance that Crown Sydney will lure additional VIP gamblers to Sydney, and that some of these will also pass through The Star, thereby increasing the pie for both companies.

Elsewhere in Echo’s portfolio, there’s also an opportunity to upgrade its Gold Coast property or develop a new casino in Brisbane. It’s early days for these projects, and they may also face competition, but they could add meaningful value to the company.

If we apply less bearish – but still by no means bullish – assumptions to Echo’s future, it could be worth more than $4 per share (see Table 1).

This is a complex, fluid situation for sure, but casinos remain an attractive business (see Friday Fishing: Punting on casinos from 30 Mar 12 (No View – $4.38)) and, with all the bad news priced in, Echo offers a ‘heads we win, tails we don’t lose too much’ opportunity. It’s a lot better than anything you’d be offered either side of Darling Harbour.

Echo’s share price is down 26% since Casinos: Interim results 2013 from 21 Mar 13 (Hold – $3.63) and we’re upgrading to BUY.