‘In the casino, the cardinal rule is to keep them playing and to keep them coming back’ says Sam ‘Ace’ Rothstein in the unoriginally titled movie Casino. Played by Robert De Niro, Ace’s comment succinctly explains the casino business.
Despite the house advantage, the vagaries of luck mean punters often win in the short term which, ironically, usually means they stay longer and give it all back and more. Encouraging the perception that winning is possible despite the odds underlies the gambling business. This is why casinos in the US – where regulations allow large jackpots from linked slot machines – make sure to publicise the periodic jackpot wins by lucky punters whilst the slots themselves are designed to offer punters regular small wins to encourage them to keep playing.
Theoretical win rate reduced
Continuing to invest in casinos
Increasing price guide
This isn't the place to discuss the morality of all this but most punters of course ultimately lose. So we’re not too concerned that six lucky VIPs savaged the latest half-year results of The Star Entertainment Group (formerly known as Echo Entertainment Group). Their achievements meant the company recorded an actual VIP win rate of 0.88% in the half, even lower than the 1.00% actual win rate for the four months to 31 Oct (see Echo AGM: A Star is born), suggesting the festive period was anything but for the company.
Theoretical win rate
Both the casino’s and VIPs' luck will even out over the long term. However, due to the short term volatility in earnings caused by luck, casinos report ‘normalised earnings’ that adjust their actual result for the theoretical win rate that the casino should earn from VIPs over the long term.
|Six months to 31 Dec||2016||2015||2016||2015|
|Theoretical win rate (%)||1.35||1.35||1.43||1.43|
|Non-gaming & other ($m)||140||131||140||131|
|Total revenue ($m)||1,227||1,142||1,246||1,160|
Although you should always be sceptical when management emphasises metrics other than actual results, the large amounts wagered by VIPs and the resulting volatility in earnings mean that ‘normalised earnings’ are a better way to assess a casino’s performance.
However, this is only true if the theoretical win rate used by management is appropriate. As we’ve previously argued (see Echo AGM: A Star is born), the 1.43% rate chosen by Star management appears too high and the 2016 interim result added further weight to this argument.
With the company’s historical average actual win rate now below 1.43% and VIPs wagering increasing amounts in recent years, management has now decided to cut the theoretical win rate to 1.35%. This is in line with the rate used by peers such as Crown Resorts and Sky City Entertainment and we think it's about right.
With VIP turnover above $23bn in the first half of 2016 (which was similar to 2015), this seemingly minor 0.08% difference leads to big differences in earnings. As you can see in Table 1, it reduced net profit (NPAT) by 8% in the first half of 2016.
This change shouldn't, however, take away from the fine job done by management in reviving the company’s fortunes in recent years.
Keeping them coming back
A major reason for this is the nearly $1bn spent upgrading its flagship property, The Star, Sydney, which has led to big jumps in revenue and earnings before interest, tax, depreciation and amortisation (or EBITDA) (see Table 2). Star Entertainment's Sydney casino has had the added advantage of a stronger NSW economy compared to Queensland’s but all the company's casinos have benefitted from low petrol prices, low interest rates and increasing tourism as a result of the declining Australian dollar.
|Year to 30 Jun||1H16||2015||2014|
|The Star, Sydney – revenue ($m)||885||1,639||1,304|
|Qld casinos – revenue ($m)||353||692||630|
|The Star, Sydney – EBITDA ($m)||223||356||284|
|Qld casinos – EBITDA ($m)||87||165||136|
|The Star, Sydney – EBIT ($m)||172||257||194|
|Qld casinos – EBIT ($m)||55||100||80|
|Note: figures normalised at 1.43% theoretical win rate, Qld casinos include Jupiters Townsville to 30 Sep 14|
Yet casinos require fairly constant capital expenditure to 'keep them coming back'. All the more so in Star Entertainment's case as competitors Crown and Sky City Entertainment spend billions and hundreds of millions respectively sprucing up their casinos in Australia and New Zealand.
The greatest threat is Crown's 6-star Crown Sydney casino – now due to be completed in 2021 – which was cited by management in announcing a further $500m investment in The Star, Sydney during its 2015 result. Crown Sydney is also the reason management recently proposed an additional $500m investment in expanded VIP gaming and accommodation, with the cost to be split between Star Entertainment and its joint venture partners in the redevelopment of its Brisbane casino (see Echo turns tables on Crown in Brisbane).
This is on top of the $1bn to be spent in Brisbane, the $350m currently being spent upgrading its Gold Coast casino and a further $500m investment (again split with its joint venture partners) that's planned for its Gold Coast property. These aren't insignificant sums by any means but the company should be able to finance this investment through free cash flow and increased debt unless its performance materially deteriorates in coming years.
Increasing price guide
The construction of larger and more luxurious facilities by the various operators will help attract more foreign VIPs to Australasia and thereby likely expand the overall market. However, unlike Crown – which has monopolies in Melbourne and Perth along with a currently depressed 34% investment in Melco Crown Entertainment – Star Entertainment will face competition in Sydney from 2021 (albeit limited to VIPs, at least initially) and potentially also in south-east Queensland in coming years. There is also the risk that slowing economic growth will hit profits just as its capital expenditure is ramping up.
When we sold out of this stock for a 50% gain back in 2014, we noted that we could be leaving plenty of value on the table if the performance of The Star 'continues to improve at a rapid clip' (see Echo downgraded to Sell on 7 Nov 14 (Sell – $4.02) and so it has proved. We felt that the margin of safety had disappeared, but we were probably too cautious. With the stock now almost 50% higher again, though, and sporting a price-earnings ratio of 18, we certainly don't see any margin of safety at these levels. Nevertheless, given the improved performance, we’re upping our recommended Buy and Sell prices, to $3.50 and $7.00 respectively, which in turn means an upgrade to HOLD.