A prized asset at distressed prices

Ramoun Lazar

Firetrail Investments

The Australian gambling industry is mature, with deep penetration among the population across slots and gaming tables. Growth rates are therefore similar to GDP and household disposable income growth. Casinos have been taking share of the overall gambling sector, albeit this has been largely driven by higher rates of growth among VIP style gaming. 

The chart below highlights the key Casinos in the Australian marketplace. Casinos typically operate privileged assets under long term licenses. This provides a key barrier to entry and assets that exhibit monopolistic style earnings streams.

We believe Crown is the highest quality Casino in Australia with the best assets. We estimate Crown accounts for around half of the industry earnings, see chart below, with 85% of earnings derived from higher-margin, more predictable main gaming floor operations.

Why did Firetrail invest in Crown Resorts? 

The NSW Independent Liquor and Gaming Authority’s review of the suitability of Crown Sydney to hold a NSW gaming license created the opportunity for us to acquire a position in Crown Resorts last November. Our thesis is based on four key pillars: 

1. Valuation – the opportunity to buy a portfolio of privileged assets at a significant discount to fair value. This argument is supported by book value as well as Crown’s relative valuation multiples. We estimate the value of Crowns licenses and land and buildings, net of debt, at around $7.30/share. Pre the Blackstone proposal to acquire 100% of Crown, the stock was trading at only a modest premium to book value. Assuming Crown can retain its gaming licenses we believe we paid very little for the profit-generating operating business. Earnings multiples continue to trade at a discount to Crown’s historical relative range, suggesting the Blackstone bid continues to undervalue the earnings power of Crown’s assets in Melbourne, Perth and ultimately Sydney. 

2. Licenses, fines and social and governance change 

The second pillar of our thesis rests on confidence Crown will ultimately overcome the current regulatory scrutiny centred around governance, how it dealt with VIP junket operators and money laundering. Extensive engagement with the Crown Board, and specifically Chairman Coonan, has provided confidence Crown understands the changes that are required to be deemed suitable to hold a gaming license in NSW, VIC and WA. 

This is underpinned by some of the changes seen to date, including extensive Board and management renewal, the cessation of direct information sharing with representatives of Consolidate Press Holdings, the cessation of dealings with Junket operators unless approved by regulators and increased compliance and anti-money laundering investment. 

We also believe that once Crown is through the current uncertainty it should emerge as a positive Social and Governance story. New Crown will be a lot more transparent, shareholder friendly and ultimately should possess better earnings quality (less reliance on opaque VIP). We believe these are all catalysts for a multiple re-rating of the stock. 

3. Earnings power will not be impaired 

We believe the likely significant reduction in VIP earnings will not materially impact Crown’s earnings power in a postCovid operating backdrop. As you can see from previous charts VIP only accounts for around 10% of group EBITDA. This pales in comparison to the Main Gaming floor, which accounts for nearly 90% of EBITDA. Main Gaming is higher margin, we estimate EBITDA margins around c.3.5-4x VIP, mainly due to the absence of commissions. 

Under the previous VIP model, Crown was paying junket operators (c.75-80% of VIP turnover) large commissions/rebates in order to attract gaming “whales” to its Casinos. Crown’s decision to stop dealing with junket operators effectively means these VIP earnings are unlikely to recur. We believe these lost earnings can be easily overcome through a combination of cost outs, alongside increased focus on direct VIP marketing, where margins are higher because no commissions are paid to junket operators. 

4. Cash, cash and cash… and improved returns 

The final piece to our Buy thesis is the most exciting. Crown will effectively become a cash generation machine post completion of the Sydney Tower and Casino capex, which is expected to be completed through 2H21. Capex will effectively fall to $130-150m over the next 2yrs, compared to depreciation of around $300-330m. This will underpin significant free cash flow as casino earnings recover post-Covid disruptions, resulting in rapid deleveraging of the balance sheet. On our estimates Crown could be almost debt-free by FY23, providing scope to undertake significant capital management in the form of buybacks over the next several years.

 

Conclusion – it is going to take time to play out but significant upside remains. 

Blackstone’s initial $11.85/share bid to acquire the remaining shares in Crown Resorts it does not already own vindicates our thesis on the stock, albeit we believe still significantly undervalues the assets. Our fair value on the stock is materially higher than the Blackstone bid. We believe the stock can continue to re-rate to this higher fair valuation over time just by continuing to execute on the transformation strategy currently in place. This will be aided by a post-Covid earnings recovery – the initial signs are that gaming revenues have rebounded strongly when Casino’s move to more normal operating conditions. 

Blackstone’s bid is an opening salvo to show its hand while Crown is still weakened by a significant amount of regulatory and Covid related uncertainty. As things improve, we believe there is scope for this bid to increase on a risk adjusted basis. If there is not an increased bid and Blackstone walks, we believe Crown will re-rate anyway over time. As such it would not be wise to give away the house cheaply.

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Ramoun Lazar
Analyst
Firetrail Investments

Ramoun is an Equity Analyst at Firetrail Investments. Ramoun’s primary sector responsibility is Resources stocks. Ramoun has over 17 years relevant industry experience.

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