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Morningstar | Continuing International VIP Recovery to be Main Driver of SkyCity Earnings Growth in Fiscal 2018. See Updated Analyst Note from 24 Jul 2018

We've lowered our near-term earnings estimates slightly for narrow-moat SkyCity Entertainment. Our fiscal 2018 normalised EBITDA and EPS estimates fall by around 1%, to NZD 332 million and NZD 24 cents per share, respectively, mainly reflecting lower margins in the international VIP business. Nonetheless, our long-term earnings estimates are broadly unchanged, and we maintain our NZD 4.20 (AUD 4.00 at the current spot rate) per share fair value estimate. We project 7% annual EBITDA growth on average during the next five years. This assumes mid-single-digit revenue growth for the next five years, underpinned by steady performance in Auckland, and further recovery of International VIP turnover, more favourable mix shift, and operating leverage. Management recently guided to fiscal 2018 revenue growth of 5% in fiscal 2018, while EBITDA should grow slightly slower at around 3% due to the aforementioned VIP margin pressure.

In the near term, international VIP margins are likely to come under modest pressure as the reliance on junkets increases. We forecast the division's EBITDA margin to be around 19% during fiscal 2018, compared with the 21% average during the past three years. However, VIP EBITDA margins should recover by around 300 basis points to 22% by fiscal 2020, underpinned by high levels of operating leverage, and recovering revenue. The company is targeting IB turnover of NZD 10 billion, although we believe this is still a very low base and the company should return to at least fiscal 2016 highs of around AUD 12 billion within the next three years. The VIP gaming market in Australia and New Zealand has moved on from the challenges in late 2016, and in our view, there is still considerable headroom for growth. Given the ongoing major reinvestment program, and New Zealand’s proximity to Australia and attractiveness as a tourist destination, SkyCity is well placed to capitalise on growing VIP volumes in the region, especially from Chinese high-rollers.

Shares in SkyCity are fairly valued at the current price. While the company is undertaking several initiatives which are likely to drive accelerated earnings growth, we see limited near-term drivers for a rerating. Longer term, earnings growth hinges on successful execution of the convention centre in Auckland, and Adelaide expansion. While we are optimistic on the outlook for the Auckland facility, Adelaide prospects are less clear. While a key benefit of the program is the casino licence extension out to 2035, we don't envisage returns on the additional capital expenditure in Adelaide exceeding the company's cost of capital. Management pushed out the timing of the Adelaide expansion capital expenditure, due to the updated construction programme from the builder Hansen Yuncken. We’ve adjusted our capital expenditure forecasts as the bulk of the expenditure will occur during fiscal 2020, although the total quantum is unchanged at AUD 330 million.

The company's cashflows will be constrained for the next three years as its NZD 1 billion expansion projects near completion. We forecast net debt peaking at just over 2 times EBITDA in fiscal 2020, although we expect this to revert to around 1.5 times within three to four years of project completion, as the expansion benefits flow through to earnings. We are comfortable with the balance sheet health, and believe the defensiveness of casino earnings will see the company sail through the capital expenditure hump without material pressure on SkyCity's financial position.