Why the decks are stacked against Sun International

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Sun International, the iconic gaming and hotel group, is dicing with debt in a high-risk game where its rivals are watching closely — with their cards clutched to their chests.

There are huge stakes at play in a highly competitive gaming sector where casinos are now battling to compete with fast-growing electronic bingo terminals, limited payout machines and sports betting. The odds, at this delicate juncture, are much stacked against Sun, which has just launched a R1.5bn rights issue to ease some of its hefty debt load.

It’s perhaps the lowest point for a company that shot to international attention when a then 44-year-old hustler named Sol Kerzner opened the glitzy Sun City in 1979, at a cost of R35m. Kerzner wasn’t exactly a novice: he’d already opened SA’s first five-star hotel, the Beverly Hills, in Umhlanga in 1964 despite much scepticism. But Kerzner threw big money at Sun City, wooing the world’s top golfers with the promise of the first US$1m prize, and offering similar cheques to lure music stars including Tina Turner, Queen and Sting to play at the venue, in defiance of the cultural boycott of SA during apartheid.

Thanks largely to this, Sun International became SA’s most successful hotel group. It listed in 1984 and its share price sparkled like the sequins on one of Kerzner’s Extravaganza dancers, But democracy wasn’t great for the group. Suddenly, casinos were allowed to operate in the big cities, not simply "homelands" like Bophuthatswana, where Sun City was located.

Kerzner, the "Sun King" who was lauded as "great" by none other than Donald Trump a few years back, eventually sold out of the company that m ade him famous. Arguably, the company has been going sideways ever since he left.

Over the past decade, Sun International’s share price has gone nowhere. It is 54% lower than it was three years ago, while the JSE’s all share index is up 9.7%.

But Kerzner’s former company is at a tipping point. And it dare not overplay its hand.

The state of the game is that Sun has bet big on a new casino development. At this point, investors are still at the table, hoping Sun has an ace up its sleeve, rather than simply trying to bluff its way through until the economy deals it a better hand.

The fact is that Sun, which has a market capitalisation of around R6.4bn, is lumbered with a debt load of R15bn. To service its bloated interest bill, Sun had to pay more than R1bn out of its operating profit last year.

Last week, Sun released its financials for last year, which showed just how much this debt is weighing on its bottom line. From its remaining operations it scraped together a forgettable R38m profit. Understandably, it chose not to pay dividends.

But the deeper question is, should investors plough more money into the R1.5bn rights issue?

There’s not an obvious answer, since Sun’s core casino operations in both SA and Latin America are struggling to grow. And the prospects for a meaningful spurt in casino profits in SA and Latin America are looking vanishingly slim right now.

FNB Securities, for one, isn’t convinced. Last week, it said it expected earnings downgrades at Sun if SA’s trading environment remains weak for longer. While the share price is relatively cheap (a forward p:e of 7.4), the outlook is cloudy, with significant risk. "We will avoid this counter at least until after the rights offer has occurred."

Sun seems to have bet the house on its new Time Square casino precinct in the vibrant Pretoria suburb of Menlyn. It is the second-largest casino complex in the country, behind Grand West in the Cape.

But the problem is that Time Square — which accounts for over R4bn of Sun’s total debt — has got off to an ominously slow start, underscoring just how competitive the gaming market is in SA. Of course, it must be said that debt levels often start out high for casino and hotel operators, in the expectation that they’ll pull in strong and reliable cash flows. But with too few people flocking to the 2,000 slot machines and 60 casino tables at the Time Square casino right now, that hope is looking pretty tenuous.

A Financial Mail analysis shows just why investors are right to be worried.

By June 2016, debt attributable to Sun was R10.9bn. But it crept up to reach R11.4bn in just six months, as the costs of developing the Time Square casino mounted.

Last week’s results showed that by December, Sun’s SA debt was R12.3bn.

Little wonder that CEO Anthony Leeming spoke of how the company has had to shift focus and is "committed to getting the basics right, operating as efficiently and optimally as possible".

In all, Time Square alone accounts for nearly a third of the R12.3bn debt, another R2.3bn is tagged to the various operating subsidiaries and R3.8bn is owed by the "central office". In Latin American, Sun International also owes R1.2bn for Sun Dreams, and R811m for Sun Chile.

By December 2017 its debt-to-earnings ratio for its SA business was at 3.7 — a little uncomfortable, but still within Sun’s target of less than four times earnings.

In its most recent annual report, Sun predicted that its SA debt would peak with the construction of Time Square, and would start to drop once the venue opened. If only.

The upside for Leeming’s company is that Sun was able to generate cash from operations of R3.73bn last year — R3bn after tax and changes to its working capital. This is equivalent to a healthy R31/share, which, if anything, shows Sun’s cash-flow prowess.

But the debt makes all the difference: the interest paid of R1.2bn and the R2.6bn spent on investments meant that, in the final analysis, Sun had a net cash outflow of R965m.

Leeming (48), who has been at the group for 19 years even though he took the CEO seat only a year ago, will have his fingers crossed that Time Square comes up aces. The new development is in fact a relocation of the old Morula casino licence, which had been gradually dwindling for years, in part due to competition from limited payout machines and electronic bingo terminals, as well as its less-than-vibrant location at Mabopane, outside Pretoria.

Whether Sun, with hindsight, would have pursued the same relocation plan to Menlyn if it knew what it knows today is an interesting question.

But then, it didn’t have too many dice to roll. Two years ago Sun launched a R9.4bn takeover bid for rival casino group Peermont, which owns Emperors Palace and nine other casinos. But the deal was shot down by the competition authorities. Had the takeover succeeded, Sun’s operating profile in Gauteng would have changed dramatically.

For one thing, Sun was forced to pay "settlements" to rival gaming entities that had argued that Time Square would disrupt their Gauteng operations — including a R750m settlement to Peermont.

Sun International has big debts, thanks mainly to the launch of Time Square

—  What it means:

In an interview with the Financial Mail, Leeming played his cards close to his chest when asked if the Time Square casino would justify its heavy development cost. He said he could not "make a call" at this early stage.

More forthright in his assessment of Time Square was Hassen Adams, chairman of Grand Parade Investments, one of the main empowerment partners of Sun’s SunWest operations that include Western Cape-based casinos GrandWest and the Golden Valley in Worcester.

When reflecting on GrandWest’s consistent profit performances at a recent investment presentation the plain-spoken Adams described Time Square as "a disaster of monumental proportions".

Another gaming industry executive who spoke to the Financial Mail said the underwhelming opening at Time Square suggested Sun was "pissing money against the wall at a ridiculous rate".

Other informed sources were a tad more diplomatic, saying Time Square is a top-notch casino development that has the potential to become one of the best casino properties in SA over the longer term. The problem, though, is that Sun might not have the luxury of time.

Says one well-placed industry source: "Menlyn’s a nice casino but it’s not a Monte [Montecasino]. It was wishful thinking in a way to think that Time Square was simply going to rip away market share from other Gauteng establishments. At this point there has been no significant amount of clients peeled away from the large casino properties around Johannesburg."

But all casino operators are battling.

For the year to June, Peermont reported a 10% drop in revenue at Emperors Palace. The signals were also mixed at Tsogo Sun, which owns Montecasino, for the six months to September. Montecasino’s revenue fell 5%, while the smaller Silverstar casino’s takings fell by 7%. Gold Reef City grew, but at a minimal 3%.

At the outset, Sun’s projections were all blue sky. Time Square was set to grab 18% of the lucrative Gauteng gaming market, it projected. But in its most recent results presentation, Sun revealed that even though the Gauteng market grew strongly by 4.4% in the second half of 2017. Time Square snagged only a 13% market share — far below expectations.

For the eight months to December, Time Square generated revenue of R827m, with casino revenue of R744m. Though it recorded an operating profit of R26m, it made a bottom-line loss of R345m.

Its 22% Ebitda (earnings before interest, taxes, depreciation and amortisation) margin is well below that achieved by other flagship casinos like Montecasino (41.4%), Gold Reef City (35.9%) and Emperors Palace (32%). At this point, Time Square’s margin is more aligned to smaller Gauteng casinos like Silverstar (29%) and Sun’s own Carnival City (26%) in Brakpan. While this margin should improve, the competitive nature of the Gauteng market means margins have never been as fat as those seen in the large Western Cape and KwaZulu Natal casinos.

Leeming told the Financial Mail, however, that trading activity seems to be picking up at Time Square – even if the lower win-ratio at its casinos means this growth has yet to translate into bottom-line profit.

It should pick up especially since, in some parts, Time Square still resembles a building site.

This week, Time Square will open its 238-room hotel ahead of the Easter weekend, which Leeming hopes will boost its revenues — with overnight visitors and bigger-spending VIP guests visiting the casino. The Gauteng Liquor Board has also approved extending trading hours at Time Square.

But if, as some fear, Time Square takes time to find traction, is the R1.5bn rights issue not too little too late?

Several gaming sector analysts and casino executives argue that Sun would have been more prudent to raise capital earlier. And that it should have raised at least R3bn-R4bn to pay back more debt.

Avior Capital Markets gaming and leisure sector analyst De Wet Schutte says the capital-raising is lower than expected.

"I would have thought more capital was needed to comfortably see the company through a challenging time, considering all the risks the industry is facing. Sun does generate good cash flows — but casinos are actually quite capital-intensive businesses that require lots of reinvestment," he says.

Allan Gray portfolio manager Duncan Artus, on the other hand, argues that the rights issue is well pitched at R1.5bn. Allan Gray, a large shareholder in Sun with a 9.33% stake, will support the rights issue.

Says Artus: "What we don’t want, of course, is to give Sun too much capital. It takes off the pressure. It does not help to give them R3bn. Rather give them what they need for long-term value creation."

But whether shareholders get a decent payback hinges heavily on whether Time Square can spin strong cash flows.

Artus says Time Square’s prospects could be different after the opening of the hotel. And he says Leeming’s team is running a tighter ship. "Management remuneration is now far more aligned with the interests of shareholders, and there has been a re-focus on the cost base that has already shown in the second half of the year to December, in the form of Ebitda growth."

But it has other struggling casino properties too, like the Boardwalk in Port Elizabeth, which is being restructured to be more profitable.

Schutte is stoic around prospects for Time Square. "This casino is not even a year old. It did open at the worst possible time in terms of a weak economy, but the newly opened hotel should benefit the casino. It’s too early to cast judgment on Time Square’s long-term prospects, remembering that this is a 10-year project."

Schutte does admit that the gaming sector has changed dramatically in recent years, thanks to limited payout machines, the rise in sports betting as well as new taxes, changes to regulations and smoking bans. "The millennial consumer is throwing up challenges to the casino sector. There is a move to more skills-orientated gambling rather than the ‘chance’ element of casinos."

Sun has grasped the nettle in Latin America, which accounts for 29% of its revenues. The loss-making Sun Nao Casino in Colombia was closed, and the Ocean Sun Casino in Panama was downscaled by shutting the 66th-floor casino and slashing staff.

In Chile, its flagship Monticello Casino (the largest in the country) has had a rough year. Last July, the resort, about 150km from Santiago, was closed for two weeks when a 42-year-old man lost his life savings at a roulette table, and promptly shot and killed two casino employees.

Financially, Monticello has been dire: revenue was down 10% to under R1.7bn and operating profits slumped 38% to R265m.

The Ocean Sun casino in Panama showed an operating loss of R162m off turnover of R223m, while the Peru casinos had an operating loss of R3m off turnover of R277m. All of which means that at this point, there will be few of Sun’s bigger shareholders who share management’s enthusiasm for broadening exposure to Latin America.

Leeming’s team still wants to hike Sun’s stake in Sun Dreams from 55% to 65% (albeit subject to finalisation of a 10-year bond issue). Dreams, which could raise fresh capital by listing on a Latin American bourse, has submitted bids for three municipal licences currently operated by rivals and is investigating expanding into Argentina.

But given Sun’s debt headache, some investors would argue the company should be consolidating its operations, not pressing ahead with its global plan (even though its Latin American debt is ring-fenced).

Sun does, after all, have a horrid record of allocating capital poorly. Back in 2007, the company bought back an immense amount of shares at a time when the share price was high — more than double its low levels of around today’s share price of R58.

And besides the Latin American expansion, its decision to buy the Maslow hotel in Sandton from Southern Sun and then plough in R250m has been disappointing, as has its unsuccessful tilt at Peermont. Time Square is just the latest in a patchy record of bad ideas.

So why does Sun keep getting it wrong? One gaming industry source says the biggest difference between Sun and its larger rival Tsogo Sun is the lack of "adult supervision".

"Tsogo has a strict and astute parent in Hosken Consolidated Investments (HCI) that made sure the gaming operations were kept in check," he says. Tsogo spent more prudently on its casino and gaming operations, allocating capital in a smarter fashion.

As things stand, Sun’s endeavours have ironically strengthened the hand of its biggest rival, Tsogo. To reduce its debt (and perhaps the odds of hostilities over a second casino licence in Cape Town) Sun offered to sell influential stakes in GrandWest and the Golden Valley casino to Tsogo back in 2016.

The initial deal was quashed by the competition authorities — but a revised deal gained Tsogo significant minority stakes in GrandWest and Golden Valley. This means Tsogo owns a stake in all five Western Cape casino licences — which could have big implications in the years to come (see story on Western Cape casinos on page 26).

Tsogo has also cleverly invested in revamping its cash-spinning Gauteng casinos Gold Reef City and Montecasino, and SunCoast in Durban, to position them for any improvement in discretionary spending.

At the same time, Tsogo also bought highly profitable limited payout machines and electronic bingo terminals business from HCI subsidiary Niveus. These businesses are disruptive to casinos, but will probably prove to be more of a threat to Sun and Peermont than to Tsogo.

At the least, Sun’s R1.5bn rights issue will allow it to keep its cards close to its chest for a while longer. But if Time Square keeps lagging, Sun’s options will diminish to the extent that it will either have to raise cash again (at a bigger discount) or sell smaller casinos or hotels. The second option could work, as Sun has enough smaller casinos and hotels to bundle together into a separate vehicle that could be sold to a private equity or empowerment investor. Of course, now isn’t the best time to sell these assets.

But if it could find a way to reduce its debt, Sun’s SA portfolio would look far more attractive. GrandWest, Sibaya in Durban, a revamped Sun City, Time Square and Carnival City along with the Table Bay hotel and the underrated Sun Slots limited payout machines operations that generate over R1bn in revenue annually, would be an easy sell.

The trouble is, that looks a long way away right now. Sun will be hard pressed to maintain its poker face in the next 18 months, but it’s clear that something has to give, or the game will be up.