Sun International restructures portfolio after years of underperformance

Posted On Monday, 27 October 2014 10:43 Published by
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Sun International, South Africa's second-largest casino and resort operator, is undergoing significant change after years of underperformance.

Sun International hotel

First, consider the environment. Casinos are effectively local monopolies in South Africa because competition is restricted by the finite number of licences available. However, they do have to compete with what consumers spend on goods and services, as well as other forms of leisure activity.

The problem is that growth in gross gaming revenue has been slow since 2008, lagging growth in turnover of listed retailers by far more than we expected. In a typical casino, 30% of customers can generate more than 70% of revenue. These customers have probably not benefited to the same extent from credit extension and strong growth in the public-sector pay bill and social grants as those who have driven retail growth.

Customers still visit casinos, but they spend less per person than before. This causes margins to fall as casinos incur the same costs, but receive less revenue. Other than the taxes paid, a casino's short-term cost base is mostly fixed, magnifying any change in revenue on the bottom line. It is difficult for casinos to raise prices (this would mean changing the win ratio) to offset rises in costs. So if that is the environment, what about Sun International specifically?

Well, the figures show that its share price, its margin and its earnings have yet to match the peak they reached in 2007/9 Reasons for this include: •

  • Turnover growth at casinos slowed down materially, causing profit margins to fall
  • It invested too much capital in Port Elizabeth to renew the licence and exclusivity of the Boardwalk Casino
  • Investors are concerned about the implications of the potential loss of exclusivity, or the amount of capital needed to maintain exclusivity, in Cape Town for GrandWest Casino
  • Equally, concern has been raised about the regulatory risk and higher tax rates on gaming revenue
  • Hotels are struggling to sell rooms in an oversupplied market since the World Cup in 2010.

So what has Sun International done about this? Pretty clearly, when a company or industry goes through a tough period, change invariably comes about. Senior management changed at Sun International. After reviewing the business, decisions were made to aggressively reduce costs and restructure the portfolio of assets.

Faced with negligible growth in gaming revenue, low hotel occupancy and the need for continuous capital investment to maintain operations, Sun International's management had to take a hard look at the cost base, and search for new revenuegenerating opportunities.

The cost base has been significantly restructured, and the potential cost saving seems to be as high as R300-million. On a revenue base of R10billion, a R300-million saving goes a long way to restoring margins without relying on a rebound in gaming revenue.

Sun International also has plans to restructure its portfolio. The idea is to reduce its risk, sell low-return assets and put the money into assets with better returns. So, for example: SunWest: it has proposed selling 14.8% of SunWest which owns GrandWest Casino, Table Bay and the Worcester Casino to Tsogo Holdings, a potential rival bidder for a new casino in Cape Town, for R635million.

Tsogo has also bought a further 25% from Grand Parade Investments

  • Monticello Grand Casino Chile: it has plans to invest R1.3billion to buy out its partners, increasing its exposure to one of Latin America's best casinos, which it already manages
  • In the African operations: it has planned to sell its majority stakes in all African operations, except Nigeria, for R664-million. This is at an attractive valuation considering the future capital investment the operations need
  • Morula Casino: it has applied to move the licence from the declining Morula Casino to Menlyn in Pretoria, while investing R3-billion in a casino development in the attractive and under-serviced Pretoria market
  • Grand Parade Investments slots: it has planned to buy a 25% stake for R285-million, with an option to acquire up to 70%, as limited payout machines and electronic bingo terminals continue to grow much faster than the casino market
  • Panama and Colombia: it has invested over R1-billion in a casino in Panama City, which opened in September, with attractive economics. The investment in Colombia is far smaller, but creates opportunities for potential expansion
  • Sun City: despite its R1.4-billion in revenue, Sun City generates little cash flow after capital expenditure. There is the potential to significantly increase cash flow by turning Sun City into a destination casino once again on a restructured cost base.

With a very high replacement value, Sun City could also possibly be sold at an attractive price. Of course, there are still risks in the business. These include low revenue growth, the prospect of a full public smoking ban in South Africa, higher taxes and potentially bad capital allocation in Latin America.

But there are also potential upsides: an unexpected recovery in gaming revenue in South Africa, for example, would result in a meaningful increase in cash flow given the lower cost base. In addition, the cash flow needed to be spent on maintaining the operations would reduce as a proportion of revenue.

Also, with the major global casino operators focusing on Asia, Sun International has the opportunity to continue growing in Latin America without having to overspend to establish or acquire new casinos.

The share price has already begun to discount many of the changes in the business, but we believe Sun International provides an attractive opportunity on depressed cash flows in an expensive stock market.

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