Taking a punt

By Roger Armstrong

Saturday 1st March 2003

Let's face it; our so-called friends across the Tasman don't rate us. Australians are condescending towards our politics, our sports teams and our business scene. In the world of finance they have until recently snubbed our share market, criticised our companies and bemoaned our management.

But there is one corporate in the New Zealand market that gives us bragging rights over our competitive Okker mates - Sky City. From a financial perspective, its casino is undoubtedly the best casino/gaming operation in Australasia. Its Auckland hotel's occupancy rates have outstripped those of all other major Auckland hoteliers during the past two years, and its Sky Tower has avoided the post-opening visitor downturn typical of such facilities. Sky City management knows how to extract money out of punters' pockets with more efficiency and speed than a high-class hooker.

For its achievements, the company is now rated by investors at a premium to other Australasian gaming stocks and has attracted a number of Australian shareholders. Profit margins of 53-54% in the past two years leave the Australian casino companies in the dust with their miserly 20-30% equivalent margins. This, and other aspects of Sky City's performance since it took over operation of the Auckland casino from US gaming giant Harrahs in 1998, sees the company trade on a price:earnings ratio of 16 relative to ratios of 11-13 for its Australian counterparts.

While the margins are impressive, the bigger part of the value creation story is the growth achieved. Although Sky City does not break out separate balance sheet figures for the Auckland operation, it is a reasonable bet that the company has not substantially increased capital employed at its core site over the past five years while taking EBITDA from $88 million to an estimated $200 million in 2003.

This means all the operating profits post interest and tax have been available to pay dividends, buy back shares and invest in other operations. Many companies have produced the growth of Sky City's operation but most do so by adding more capacity/stores/working capital.

To grow profit this strongly within the limitations of a single building has been a phenomenal effort. The Auckland operation probably now makes about 35% return on capital employed, making it one of the most profitable businesses on the stock exchange. The huge and growing cash flows spiralling out of the Sky City Auckland complex have seen the company pay out accumulated dividends of $315 million since 1996.

Of course, increasing Asian immigration into Auckland has given the company a helping hand. Asians by and large love to gamble and this demographic group is hugely over-represented on the gaming floors. Also, tourism to New Zealand is performing unbelievably well, with monthly visitor numbers now regularly about 10% above pre-September 11 levels.

The government has also been helpful by not putting the original casino licence up for auction and subsequently limiting potential competitor gaming activity in the Auckland area. (Not that the company's political friends couldn't also inflict some damage should they move to ban smoking in places like casinos.)

That growth should have plateaued by now due to the physical constraints on capacity dictated by the building size. But Sky City has achieved its phenomenal margins and growth by ruthless management of its gaming floor facilities and excellent promotional activities to keep the punters rolling in at off-peak times. The company effectively employs similar tactics to supermarkets, making sure that every inch of space produces the maximum amount of profit. For example, Sky concentrates on pokies rather than the more glamorous table activities and culls out machines that do not attract customers' interest. Cunning loyalty programmes combined with clever promotional activities have given the company an understanding of its client base and an ability to entice the punters.

Sky City also has two projects underway to expand the reach of its Auckland operation. The $60 million convention centre, which encompasses an expansion of gaming facilities, should open in December this year, and the company will also build a $75 million five-star hotel on top of the centre, scheduled to open in late 2004. Convention centres and hotels are not normally big earners in their own right but should feed more traffic into the lucrative gaming rooms. Putting more money into your most profitable business is normally a smart thing to do.

Victory for New Zealand? Not exactly. Like so many other New Zealand companies, from Baycorp to Air New Zealand, the blemish on an impeccable operating record came as soon as the company attempted to invest in activities away from its central money machine. Sky City's expansion outside Auckland has to date been a mixed bag:

Sky City's $23 million investment in 22% of Australian Stock Exchange-listed internet sports-betting concern Canbet in January 2001 (increased to 32.2% in early 2003) is worth about half that amount on the share market today.

The $14 million Queenstown casino opened in December 2000 is bravely trying to achieve breakeven in a half-horse town that crazily allowed two casinos.

Sky's 50.2% investment in Force Corporation (now Sky City Leisure) is probably perceived by most as a flop, with the company writing off $28 million in 2002 and Argentinean operations hit by crisis there. However, the market value of Sky City's stake is now actually pretty close to the cash paid thanks to the advantageous underwriting of the Force convertible note issue at $1.

Sky's $50 million Hamilton casino only opened in September 2002, so it's too early to say if the investment will be a success or not. Common sense suggests it should do reasonably well, although not hugely given the location in a cautious rural town with little tourist traffic.

Sky City's biggest diversification has been the $250 million investment in the Adelaide casino, which to date has failed to really fly. Last year it made $12 million EBIT, a 5% pre-tax return. You can see what attracted Sky City to this investment - it is the only casino in a city with a similar population to Auckland. The problem is that the casino attracts about half the customers of Sky City Auckland and extracts only about 75% of the profit per person that Auckland manages. Can Sky City fix the "problem" or are Adelaide residents too provincial and conservative - it is Christchurch's sister city, after all - to let their hair down on a regular basis? Results in the first half of the current financial year would suggest that, through its promotional talents, Sky City is starting to attract the punters in Adelaide but it has a way to go before turning the investment into a jackpot.

Still, any quibbles about the company's investment performance pale into insignificance relative to the company's great operating results. Just ask anyone who invested in shares in 1996 and has since enjoyed 150% capital appreciation and dividends equal to about 60% of the original investment.

The big gains have probably been made, but don't underestimate the management team's ability to perhaps eventually make successes of its current perceived investment failures.

Roger Armstrong is an independent financial analyst. Disclosure of interest: nil

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