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GAMBLING – SLIM PICKINGS

Growth in the casino industry has slowed. Marc Hasenfuss looks at what the future holds for the sector.

About 15 years after the first licence was awarded, SA’s 37-strong casino industry is generating collective revenues of nearly R20bn. But the high-rolling sentiment reserved for casino stocks between 2003 and 2008 has largely been replaced by a new realism. Odds must lengthen during times of economic stress.

Certainly any notion that casino stocks were recession- proof (like tobacco or health care) has been eroded in the past three years — casino activity is well and truly linked to the level of discretionary spending.

Element Investment Managers analyst Matthew Kreeve says casino stocks have underperformed the JSE since 2007. “Sentiment towards them is negative, one symptom of which is fewer sell-side analysts covering the sector.”

The long-term share price movements for both listed casino groups, Tsogo Sun Holdings (Tsogo) and Sun International (SunInt), show how sentiment has turned . SunInt and Tsogo are trading at half their 2008 share price highs.

Unlisted Peermont Global, SA’s third- largest casino operator, has its bonds (listed offshore) yielding an astounding 18% after a private equity transaction left the company over geared.

Kreeve says more highly geared plays like SunInt — after its ill-timed and expensive buy-back — have suffered most. He says Peermont is an extreme example, hamstrung by its debt load and rising interest costs.

On a macro level, though, prospects for gaming in SA look sound rather than spectacular.

Kreeve says the gaming numbers have been improving this year, showing 8% revenue growth year on year in the three key provinces in the first quarter of 2012 compared with a paltry 3% in the first quarter of 2011.

A recent PwC research document on international gaming trends predicts the compound annual growth rate for the SA gaming sector between 2001 and 2015 at 6,9%. To put this in context, SA’s predicted growth is well behind Asia Pacific (18%) and Latin America (8,1%) over the same period, according to PwC.

And while it’s tough enough competing for the discretionary buck, casinos also face increasing intra gaming competition from limited payout machines , sports betting and the diversification of the racing industry into so-called “racinos”.

Then there is an additional tax of 1% of gross gaming revenue that kicks in next April — an excessive burden, some feel, on an industry that chipped in R14bn of the R17bn generated by all forms of legal gambling during 2011.

Though the casino sector may appear to be on a losing streak, the shareholder registers of listed casino companies and gaming-aligned entities still reflect substantial holdings among some of SA’s most astute asset managers and professional investors. Allan Gray, Sanlam, Element Investment Managers, the Krok family and the Ellerine Brothers all rank as sizeable participants .

Empowered investment conglomerate Hosken Consolidated Investments (HCI) has also demonstrated a strong liking for casinos in the past few years. It has played a huge role in consolidating companies like Century Star Casinos and Gold Reef Resorts into Tsogo, now SA’s biggest casino group.

HCI CEO Johnny Copelyn makes it clear the company is enjoying a great payback for its big bet on casinos. “As an emerging company, we have an investment that can produce consistent and strong cash flows … as opposed to our having to borrow money to invest in other companies.”

One thing the SA gaming industry has on its side is scale. In 2010 SA — with a market worth US$1,8bn — ranked behind France ($3,8bn) and Germany ($2bn) as the third-largest casino market in the Europe, Middle East and Africa (EMEA) hub.

The local casino sector is also sophisticated, technologically advanced and well regulated. More importantly, cash flows from both big and small urban casinos are reassuringly reliable.

Interestingly, according to PwC’s report, SA had the fastest-growing casino market in the EMEA hub during 2010 with a 3,5% increase. Peermont Global CEO Anthony Puttergill believes there are fundamental reasons why casinos still represent a compelling opportunity for investors.

He argues that, relative to other consumer-driven sectors, gaming has been resilient throughout the downturn. “The casino groups did not go as far backwards as some other consumer-linked stocks. We lagged going into the downturn, now we are lagging coming out of it .”

Puttergill believes casino operators will see the benefits of the uptick in consumer spending in the year ahead.

The upcoming year to end-March 2012 results from Tsogo should show evidence of Puttergill’s contention.

Meanwhile, encouragement can be taken from Peermont’s operating performance in the fourth quarter of the year to December 2011, where quarterly Ebitda (earnings before interest, tax, depreciation & amortisation) grew a sprightly 13,6%.

The interim performance of SunInt also showed signs of improvement with meaningful top-line growth across the company’s biggest three casinos — GrandWest in Cape Town (up from R832m to R883m), Carnival City in Gauteng (R488m to R506m) and Sibaya in Durban (R449m to R486m).

Though SunInt’s improved trading forecast is tempered by increased financing costs, Puttergill hints that earnings growth for casino companies may well surprise on the upside in the years ahead. “What we have learnt in the past few years is how to contain costs. Revenue gains are going to be well ahead of our increase in costs.”

This view is shared by Tsogo CEO Marcel von Aulock , who says there is a big difference between casinos growing revenue by 5%-6% and growing the top line by 8%- 9%. “It makes a fundamental difference to our cash flows, remembering that, for the most part, our costs are fixed.”

But though growth from existing operations could improve in the near term, investors may still refrain from rolling the dice as expansion opportunities, at least in SA, are limited.

But what about changes to the ownership structure in the casino sector? Chances of a further consolidation in the casino sector are slim, unless either SunInt or Tsogo pressed debt-laden Peermont into a debt-restructuring deal (something that might raise some serious issues with the competition authorities, not to mention a determined Peermont executive team).

Already around 90% of the local casino market is accounted for by SunInt, Tsogo and Peermont — with London Clubs International, Northern Cape Casino Consultancy and Liethlo holding a sliver of the market in the form of smaller casinos in Vanderbijlpark and the Northern Cape.

What does stand out in the trading reports from the big three casino groups is that revenue and profit contributions are dominated by a few casinos. In Peermont’s case, the Gauteng-based flagship casino, Emperor’s Palace, accounts for a chunky 58% of group Ebitda.

Tsogo earns almost 70% of its casino- generated Ebitda from its two Gauteng- based casinos, Montecasino and Gold Reef City, and its Durban-based Suncoast casino. At SunInt, more than half its total Ebitda (including hotels) is generated by three casinos: GrandWest in Cape Town, Sibaya in Durban and Carnival City in Brakpan.

Considering annual Ebitda figures of between R2,5bn and R3,5bn, one has to question whether large casino groups can really afford to expend management time and the regular upkeep expenditure on small-town operations that generate anything between R15m and R50m in Ebitda.

Tsogo’s Caledon casino managed just R16m in Ebitda in the half-year to end-September 2011. At operating profit level, SunInt’s Golden Valley generated only R6m in the half-year to end-December — hardly figuring on the income statement.

Von Aulock says the profit contributions from small casinos, some of which trade on good margins, are similar to those generated by Tsogo’s bigger hotels. “We certainly don’t ignore our smaller casino operations.”

Von Aulock adds that in SA, smaller casino groups tended to be incorporated into the larger operators, highlighting the fate of Century Star (now part of Tsogo) and Tusk (now part of Peermont).

Still, it’s worth asking whether a more mature casino industry won’t refine its structure, concentrating on enhancing margins in a handful of bigger casinos rather than trading through a sprawling mix of operations.

The big question is whether there could be an entity (private equity or gaming- focus ed) that might be brave enough to look at consolidating a portfolio of smaller casinos into a new vehicle.

Source; Financial Mail – Marc Hasenfuss