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Morningstar | Weak Domestic and International VIP Gaming Result in Earnings Downgrade for Star Entertainment

In a weaker-than-expected trading update, no-moat Star Entertainment guided to fiscal 2019 normalised EBITDA of between AUD 550-560 million. This is about 9% below our estimate and market expectations. This weakness is attributable to softer domestic gaming and a continued decline in international VIP. While some of this will be recouped in fiscal 2020 through accelerated cost-cutting initiatives, we don’t think the firm can recover the entire amount. We’ve therefore trimmed our fiscal 2019 and 2020 EPS projection by 8% on average to AUD 0.25 and 0.28 per share respectively. Our fair value also declines by 6% to AUD 4.50 per share. At the current price the stock is undervalued relative to our revised fair value estimate.

The weaker-than-expected performance is because of a few major factors. The most noteworthy is softness in the domestic gaming market. The number of visitors was strong during the second half, although the average expenditure per patron was lower. This reflects the challenging macroeconomic environment, lower hold rates on table games and the disruptive capital works at the Sydney property. We have discussed the effects of negative wealth and the lack of consumer confidence across other stocks in our coverage, and this has now extended to casinos, albeit to a lesser extent. Consequently, slots revenue increased by a lacklustre 2%, whereas table games and non-gaming revenues were  flat in the second half, all below our expectations. The challenging economic conditions are likely to linger over the next few years, weighing on gaming performance. However, over the longer term we expect domestic gaming revenue to revert to almost 4% growth per year.

The softness in International VIP during the first half of fiscal 2019 has persisted during the second half with turnover down by over 30%. While the number of visitors remains strong, the punters are playing less, with the average bet size down about 25%, reflecting slowing Chinese growth. The upgrade and expansion of the Sovereign Resorts at The Star Sydney remains on track to open by fiscal 2021, which should help improve the situation, and we forecast VIP turnover to grow at a mid to high-single-digit pace until Crown arrives in Sydney during fiscal 2022. However, we still think that despite the upgrade, the Sydney casino will struggle to compete with the allure of Crown Resorts' brand-new VIP and premium facility in Sydney. While Crown’s arrival in Sydney will expand the addressable market, we forecast Star will cede about half of its VIP and premium market share to Crown Sydney, within three years of the latter's opening.

The softer volume and revenue will result in operating deleverage, which will see group EBIT margins contract by approximately 100 basis point during fiscal 2019 to 13.9%. However, on a more positive note, the firm is accelerating its cost management initiatives, and now expects to achieve between AUD 40 million-AUD 50 million in annualised run-rate cost savings by the end of the first quarter of fiscal 2020. All these cost savings will be labour costs, most of which will be achieved by reducing the number of salaried staff who are not customer facing. Previously, each of the company’s properties were run as standalone businesses, however this initiative would see a more centralised operating model with reduced duplication across IT, HR and Finance. This should alleviate some of the revenue headwinds and help group EBIT margins increase by 70 basis points to 14.6% by fiscal 2020.

The Queensland developments are progressing to schedule. Queen’s Wharf Brisbane (the firm’s largest capital project) is currently tracking slightly below budget, and the excavation of the site should be completed within the next two months. Star has selected a preferred contractor, and approximately 60% of the contract will consist of a locked-in fixed price. This will alleviate concerns about potential budget blowouts. Meanwhile, on the Gold Coast, construction of the first joint venture tower with partners Chow Tai Fook and Far East Consortium is under way and on track to be completed in fiscal 2022. We believe the Queensland projects will plug the approximate AUD 50 million hole Crown is likely to blow into Star’s Sydney EBITDA.