South African Casino Industry

Transcription

1 CEEMEA South Africa South Africa (Citi) Industry Focus 104 pages South African Casino Industry Always Darkest Just Before the Sunrise Initiating Coverage We are initiating coverage of Sun International (1M: TP R109) and Gold Reef Resorts (2M: TP R17). We prefer Sun Int over Gold Reef. Consumer slowdown The slowdown in the consumer expenditure (driven by higher interest rates and inflation) has resulted in subdued gross gambling revenue (GGR) growth in South Africa (6-9% vs. 15% in 2007). Given the higher fixed cost nature of casinos, we would expect some pressure on margins in FY08. Kgosietsile S Rahube kgosietsile.rahube@citi.com But interest rates have peaked We analyse the performance of leisure stocks during the rates cycle. Our conclusion: the duration of sector underperformance has historically been 4 to 7 months once rates have peaked. Thus, we should expect leisure stocks to start outperforming the FINDI soon (Sep to Dec 2008). Sun International (1M): Top Pick Although uncertainty remains about weaker consumption expenditure in South Africa, this is already factored into the market expectations (share is down 40% YTD). Longer term, Sun Int l is likely to be driven by growth from new markets and its exposure to the hotels industry (c11% revenues). Trading on 9.8x rolling 12-month PE (cheapest it s been since 2004). Gold Reef Resorts (2M): Less attractive than Sun International Gold Reef Resorts is highly geared to the casino operations, with c92% of its revenues being generated from casino gambling and more exposed (than Sun International) to increasing competition in Gauteng. A new direction for growth is needed, but as yet unidentified. The new casino, Silverstar in Gauteng, could result in cannibalisation and margin dilution, given its higher cost structure. Figure 1. South African Casino Coverage Summary of ratings Gaming Stocks Symbol Rating Market Current Target Capital Dividend ETR cap US$ price price return Yield Sun International SUIJ.J 1M 1, % 4.5% 21.7% Gold Reef Resorts GDFJ.J 2M % 3.7% 17.1% Source: Citi Investment Research, Priced as at 15 Aug 2008 See Appendix A-1 for Analyst Certification and important disclosures. Citi Investment Research is a division of Citigroup Global Markets Inc. (the "Firm"), which does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Non-US research analysts who have prepared this report are not registered/qualified as research analysts with the NYSE and/or NASD. Such research analysts may not be associated persons of the member organization and therefore may not be subject to the NYSE Rule 472 and NASD Rule 2711 restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account. Customers of the Firm in the United States can receive independent third-party research on the company or companies covered in this report, at no cost to them, where such research is available. Customers can access this independent research at (for retail clients) or (for institutional clients) or can call (866) to request a copy of this research. 1 Citigroup Global Markets (Pty) Ltd

2 Contents Investment Summary 3 Investment Thesis 6 Industry Outlook 11 Health of the Consumer At a Glance 13 Wagering in an Economic Slowdown 16 Where are we relative to historical lows? 20 How far could share prices go? 21 Cannibalisation in the Gauteng Province 21 Operating Leverage Analysis 23 Private Equity in the Leisure Sector 26 Sun International 28 Investment Case 28 Valuation and Risks 31 Company Profile and Strategy 37 Sun International s journey So far so good 38 New Developments Africa and Other 38 Sun International Group Structure 41 Key Revenue Drivers 42 Cost Drivers 46 SWOT Analysis 48 Earnings Prospects 49 Gold Reef Resorts Limited 56 Investment Case 56 Valuation and Risks 58 Company Profile and Strategy 61 Gold Reef Group Structure 63 Key Drivers 64 Cost Drivers 65 SWOT Analysis 66 Earnings Prospects 67 Casino - South African Market Conditions 72 Provincial Casino Market Share GGR 78 Hotels South African Market Conditions 83 Appendix A EBITDA Margin Comparisons 86 Appendix B The Impact of Rising Rates on Individual Stocks 87 Appendix C Provincial Tax Rates 89 Appendix D Gambling Survey - It s all about the Gambler 90 Appendix E: Shareholder Structure 93 Appendix F Casino 101 and Revenue Flows 94 Appendix G South African Casinos Summary 96 Appendix A

3 Investment Summary We initiate coverage of Sun International Holdings (1M, R109 TP) and Gold Reef Resorts (2M, R17 TP). Industry A play on an economic recovery The slowdown in the consumer market, largely driven by higher interest rates and inflation, has led to subdued gross gambling revenue growth (GGR) in South Africa. The duration of the underperformance varied from 4 7 months after rates had peaked Interest rates have peaked; we anticipate the first cut in June 2009 Cannibalisation We have analysed the performance of leisure stocks during the past four rising rate cycle. Our conclusion is, generally, leisure stocks have underperformed the FINDI 1 during the rising rate cycle. Although the underperformance continued even after rates had peaked, we highlight that the duration of the underperformance varied between 4 and 7 months in the past four cycles that we analysed. However our view is that interest rates have now peaked and should start falling by June If our diagnosis that the duration of the sector underperformance has historically been between 4 and 7 months is anything to go by, then we would expect leisure stocks to start outperforming the FINDI from between September and December In the medium term, the outperformance is also likely to be underpinned by the declining rates we expect the first cut in June The gaming industry is likely to be characterised by cannibalisation in the Gauteng province due to the opening of Silverstar casino 2. Given the close proximity, Gold Reef City and Montecasino 3 are likely to be affected, while Sun International is largely immune given its geographic positioning. Sun International Top Pick Behind all doom and gloom, we like Sun International for the following reasons: Exposure to attractive assets and dominant market share: (GrandWest, Sun City, Carnival City, Sibaya and Boardwalk casino) arguably five of the most dynamic gaming markets in South Africa and the biggest casinos by revenue in its portfolio. Sun Int also possess strong casino market share, c40%. New Markets: We remain positive on Sun International s initiative to venture into new markets (Nigeria and Chile) 4. Our view is that when these developments come to market, earnings should replace cost. Exposure to the hotel sector: Hotel operations remain resilient in South Africa (i.e. strong occupancy and average room rates). The shares have been weak, down 40% YTD; however we feel that the market now fully discounts weaker consumer market in South Africa and fails to credit Sun International s resilient hotel business and the potential of new markets. 1 Financials and Industrials Index 2 Owned by Gold Reef 3 Owned by Tsogo Sun Gaming (Part of Hosken Consolidate Investment/HCI) 4 These are discussed in detail on pages 38 and 39 3

4 Gold Reef Less attractive than Sun International Geared to the casino industry: Gold Reef is highly geared to the casino sector, with c92% of revenues generated from casino gambling and only 1% from hotels; we are therefore of the opinion that a new direction for growth is needed. Asset concentration: Gold Reef generates c50% of its revenues from Gold Reef city casino (located in the competitive Gauteng province). Margin dilution given higher cost structure: The opening of Silverstar is likely to result in margin dilution given its higher cost structure. The shares have also remained under pressure, down c55% YTD. However, we highlight that most of the movement in the share price relates to the private equity deal, which was not successful after Gold Reef failed to get the right approval from various gambling boards. Global Valuation Comparisons SA casinos look attractive In figure 2, below, we highlight the various ratings of global peers in developed as well as developing markets. Comparisons between gaming companies in different countries are difficult because of varying factors (e.g. proximity of casinos to metropolitan areas, and popularity of property and tourist attraction activities). However, we look at these as a reality check. 4

5 5 Figure 2. Global Comparison Key Valuation Metrics Gaming Stocks RIC CIR Rating Cur Prices as Target at 15 Aug price Upside Mkt Cap EV/EBITDA EV/EBITDA US$ P/E '08e P/E '09e PER '08e PER '09e '08e '09e EBITDA MARGIN '08e EBITDA MARGIN '09e 2008 Div EV/EBIT EV/EBIT Yield P/FCF '08 '08 '09e US MGM Mirage Inc MGM.US 2H US$ % 9, % 27.4% 0.0% Las Vegas Sands Corp LVS.US 2S US$ % 20, % 20.2% 0.0% MGM Mirage Inc MGM.US 2H US$ % 9, % 27.4% 0.0% Wynn Resorts LTD WYNN.US 2H US$ % 10, % 21.3% 0.0% Boyd Gaming Corp BYD.US 2S US$ % 1, % 19.0% 2.2% Melco Crown Entertainment MPEL.HK 1M US$ % 3, % 9.1% 0.0% Penn National Gaming Inc* PENN.US NR US$ 3398 n/a n/a 2, % n/a n/a Ameristar Casinos Inc* ASCA.US NR US$ 1643 n/a n/a % n/a n/a Pinnacle Entertainment Inc* PNK.US NR US$ 1280 n/a n/a % n/a n/a % 21% 0.0 UK Rank Group PLC RNK.GB 1H GBP % % -5.0% 0.0% William Hill PLC WMH.GB 2M GBP % 1, % 29.1% 6.6% Ladbrokes Plc LAD.GB 2H GBP % 2, % 28.8% 5.7% % 17.6% 4.1% EUROPE Intralot SA INLr.GR 1S EUR % 2, % 21.9% 4.6% OPAP SA OPAr.GR 1H EUR % 11, % 17.6% 9.3% Berjaya Sports Toto BSTB.MY 3L EUR % 1, % 16.2% 7.4% Lottomatica Spa LTT.IT 2H EUR % 4, % 38.5% 3.9% % 23.5% 6.3% ASIA REXCAPITAL Financial Holdings 0555.HK 1H HK$ % % 75.5% 0.0% China LotSynergy 8161.HK 3H HK$ % % 42.2% 0.0% Melco 0200.HK 1M HK$ % % 10.6% 1.4% Galaxy Entertainment 0027.HK 2H HK$ % 1, % 7.3% 0.0% % 33.9% 0.4% AUZ/NZ Crown Ltd CWN.AU 1M AUD % 4, % 30.2% 6.9% TABCORP Holdings Ltd TAH.AU 2M AUD % 3, % 27.2% 11.2% Tatts Group Ltd TTS.AU 2M AUD % 2, % 17.3% 8.0% Sky City Entertainment Group Ltd SKC.NZ 1M AUD % 1, % 36.1% 6.6% % 27.7% 8.2% South Africa Sun Interntional SUIJ.ZA ZAR % 1, % 34.6% 4.5% Gold Reef Resorts GDFJ.ZA ZAR % % 36.0% 3.7% * Pls note that these companies are not covered or rated by Citi Investment Research. We use I/B/E/S consensus estimates in the calculation of multiples where appropriate Source: Powered by datacentral. datacentral is Citi Investment Research s proprietary database which includes Citi estimates, data from company reports, and feeds from Reuters and Datastream, Priced as at 15 August South African Casino Industry

6 Investment Thesis We initiate coverage on two of the listed casinos in South Africa (Sun International and Gold Reef Resorts). Our investment ratings and target prices are presented below. Figure 3. South African Casino Coverage Universe Summary of ratings Gaming Stocks Symbol Rating Market cap US$ Price Target price Capital return Dividend Yield Total Return Sun International Ltd SUIJ.J 1M 1, % 4.5% 21.7% Gold Reef Resorts Ltd GDFJ.J 2M % 3.7% 17.1% Source: Citi Investment Research, Priced as at 15 August 2008 Sun International Top Pick We initiate coverage of Sun International with a Buy/Medium Risk (1M) recommendation and target price of R We introduce Sun International as our top pick after a significant de-rating since Mid The investment case is very simple for a company that has more than 40% market share in the South African Casino gambling market. Despite there being no short-term catalysts in South Africa, Sun International is expected to generate 25% (FY08e FY11e) CAGR growth in earnings, driven by: 1) Growth from new markets (Chile and Nigeria), which we view as positive and 2) The hotel business (11% of revenues), which remains buoyant 5 in South Africa. We calculate that its investments in Chile and Nigeria should contribute c7% to NAV. Figure 4. Sun International - Abridged Income Statement (FY05a FY10e) [Rand in Millions] FY05a FY06a FY07a FY08e FY09e FY10e Revenue 5, , , , , ,002.3 Casino 3, , , , , ,651.4 Rooms , ,150.2 Food, beverage and other , ,200.7 EBITDA 1, , , , , ,467.3 Operating profit 1, , , , , ,711.8 Net finance charges (178.9) (176.0) (236.0) (577.1) (537.9) (449.3) PAT , , ,538.5 EPS (Rand cents) ,070.9 Growth in EPS 33.0% 33.2% 33.3% -6.5% 25.0% 27.4% Source: Citi Investment Research and company reports We believe that the recent share price underperformance since mid-2007 has been driven by the consumer-related concerns (i.e. lower disposable income amidst higher inflation and higher interests) and a general de-rating in the market. However, we think the market now fully discounts a weaker household consumption environment and omits Sun International s resilient hotel business operations and the potential of new markets (i.e Chile and Nigeria). 5 We forecast sustainable occupancy rates at c75% and average room rate increases largely in line with CPIX inflation 6

7 Sun International has important longerterm value upside from new markets, which could deliver better-than-expected earnings growth. In addition, Sun International also offers a portfolio of attractive assets 6 (arguably the most dynamic markets in South Africa, and the biggest by revenue in its portfolio). Currently, Sun Int l trades at a trailing P/E multiple of 12.7x and a twelvemonth rolling forward PE of 10x (on our estimates), below the ALSI forward PE of around 11x (on consensus estimates). The market does not seem to appreciate that in addition to its reasonable valuations, Sun is a growth story (outside of South Africa). At current share price levels, Sun International offers a good entry point to gain exposure to its strong cash flow returns, its resilient hotel business, and its initiative in new ventures outside of South Africa. Gold Reef Resorts Less attractive than Sun International We initiate coverage of Gold Reef Resorts with a Hold/Medium Risk (2M) recommendation and a target price of R17.00 Gold Reef Resorts is highly geared to the casino sector in South Africa, with c. 92% of its revenues being generated from casino gambling. Given a general slowdown in the gaming fundamentals in South Africa, we are of the opinion that Gold Reef is likely to be more negatively affected. Our earnings estimates for FY08e FY10e are R1.28, R1.60, and R2.12, respectively. Our FY08e estimate of R1.276 (down 15% on the prior year) is below the consensus estimates of R1.45. Despite a decline in FY08e earnings, we expect a rebound in FY09e. Figure 5. Gold Reef Resorts - Abridged Income Statement (FY05a FY10e) [Rand in Millions] FY05a FY06a FY07a FY08e FY09e FY10e Revenue Casino 1, , , , , ,687.0 EBITDAR ,034.1 Operating profit Net finance charges (0.1) (25.0) (18.0) (128.1) (88.1) (55.2) PAT EPS (Rand cents) Source: Citi Investment Research and company reports As with Sun International, the underperformance of Gold Reef shares relates to a weaker consumer market in South Africa. We think that it also relates to an increased capital spending 7 in a weaker environment. Cannibalisation in the Gauteng province We also believe that cannibalisation 8 and increased competition to draw patrons in Gauteng province added to these pressures. Then there was also the failed private equity takeout deal, whereby a consortium known as Bidco (including South African private equity firm Ethos and Goldman Sachs) were looking at taking out Gold Reef Resorts. The deal lapsed after a failure to get the right approval from the various gambling boards. According to SRP, Gold Reef had contravened four rules around securities regulations. 6 GrandWest, Sun City, Carnival City, Sibaya and Boardwalk Casino 7 Gold Reef invested circa R1bn in Silver Star Casino which opened in December 2007 in the Gauteng Province 8 Refer to page 19 for a discussion on Cannibalization in the Gauteng Province 7

8 Gold Reef trading on a trailing P/E of 11x and forward P/E of 10.4x Currently Gold Reef is trading on a trailing P/E of 11x and a twelve-month rolling forward P/E of 10.4x. We feel it is already too late to recommend a Sell rating on the counter, as the stock is already discounting a significant amount of bad news. On the back of no positive short-term catalysts, however, we initiate coverage with a Hold/Medium (2M) risk rating. Size of the South African gaming market still in its infancy Casinos have a lion s share of the gambling market, c. 75%, closely followed by Lottery and Horse betting at 14% and 8.4%, respectively. The overall gambling market is still fairly small in South Africa, currently valued at R15.6bn. Figure 6. South African Gambling Market Split, R15.6bn, FY07 Casino Gambling 75.2% Lottery 13.8% Horse Racing 8.4% LPM 2.2% Bingo 0.4% Source: Citi Investment Research and National Gambling Board With casinos dominant, this implies that the South African household spends just over 1% of its disposable income in casino gambling. The proportion of household disposable income that gambling consumes has remained largely flat in the past four years (2004=0.9%, 2005=0.99%, 2006= 1.02%, 2007=1.05%, refer to figure 8). With disposable income growth slowing, we believe there is a high probability of gambling spend remaining under pressure, and thereby resulting in slower revenue growth for casino stocks. 8

9 Figure 7. South African Gross Gambling Revenue growth Figure 8. Casino spent as a % of Household Disposable Income 25.0% 1.20% 20.0% 1.00% 15.0% 10.0% 0.80% 0.60% 0.40% 5.0% 0.20% 0.0% % Source: Citi Investment Research and National Gambling Board Source: Citi Investment Research and I-Net Industry Outlook cautious Overall, gaming revenue drivers are not entirely healthy in South Africa. Higher interest rates coupled with higher inflation are not remedying the situation. We therefore expect the household disposable income to remain under pressure, given these circumstances. Bottom-line, sector-wide revenue growth should also remain under pressure as the consumer s health deteriorates. According to figure 7 above, gross gambling revenue growth has been more robust in the past, showing mid-to-upper double-digit levels. According to recent monthly gambling statistics, revenue growth has been lethargic, ranging from mid-to-upper single-digit levels for different provinces. Given the casino s status of high fixed costs, we therefore expect casino EBITDA margins to remain under pressure. This outlook supports our neutral stance on Gold Reef, which generates 92% of its revenue from gaming. We maintain a positive long-term view on Sun International given its diversified revenue stream and overall new market opportunities. Valuation Sun International: We believe behind all the doom and gloom Sun International shares still offers good value, trading at c4.5x CY09e EV/EBITDA and 9.8x twelve-month rolling forward P/E. We use three different methodologies to value Sun International (DCF/SoTP, PER and DDM). However, we set our target price in line with our DCF/SoTP valuation to capture the value of all the casinos wholly and partially owned. A DDM and PE relative valuation suggest fair values of R and R117.50, respectively. Sun International is currently trading at R93.00 Gold Reef Resorts: Gold Reef is more expensive on an EV/EBITDA basis, but largely in line with Sun International on P/E basis. We also apply the same methodologies to value Gold Reef. Our target price of R17.00 is set to equal our DCF/SoTP valuation in order to capture the value of all the casinos. A DDM and PE relative valuation suggest values of R19.00 and R23.00, respectively. Gold Reef Resorts is currently trading at R

10 Figure 9. EV/EBITDA Comparisons Figure 10. Price to Earnings Multiple Comparisons CY09e 10 PE CY Average PE 13.7x 2 0 CY05 CY06 CY07 CY08 CY09 Sun International Gold Reef resorts Las Vegas Sands Corp Wynn Resorts LTD MGM Mirage Inc MGM Mirage Inc Rank Group PLC Berjaya Sports Toto Crown Ltd Intralot SA Lottomatica Spa Sky City Entertainment Group Ltd Melco PBL Entertainment (Macau) Gold Reef Resorts Tatts Group Ltd Boyd Gaming Corp Ladbrokes Plc Sun Interntional TABCORP Holdings Ltd OPAP SA Melco REXCAPITAL Financial Holdings William Hill PLC Source: Powered by datacentral, Priced as at 15 August 2008 Source: Powered by datacentral, Priced as at 15 August

11 Industry Outlook Before we start our discussion on the gaming industry outlook, we would like to highlight the location of all the casinos in South Africa (see figure 11 below) Figure 11. Location of South African Casinos and Market Share (%) 2% 41% 6% 4% 3% 17% 1% 8% 18% Source: Citi Investment Research and CASA 11

12 Gaming revenue drivers have been under pressure in South Africa. Higher interest rates coupled with higher inflation are not remedying the situation. We therefore expect household disposable income to remain under pressure, given these circumstances. Bottom-line, sector-wide revenue growth will probably remain under pressure as the consumer s wallet deteriorates. Provincial Gross Gambling Revenues (GGR) Remain under Pressure in Gauteng First 7 months were not encouraging Given the higher fixed cost nature of this industry, slower revenue growth could result in operating margin squeeze. Despite a new casino (Silverstar Casino, owned by Gold Reef Resorts), which opened for trading in December 2007, GGR growth remains uninspiring in the Gauteng province 9. YTD, GGR has only grown by 6.9%. Given the higher fixed cost nature of the industry, slower revenue growth should result in operating margin squeeze. In a nutshell, 2008 is likely to witness sluggish growth in GGR (as apparent on the chart below). The slowdown in revenue growth is predominantly driven by slowing consumer expenditure and the generally downbeat mood of the consumer (as discussed in the next section) Monthly revenues in the Gauteng province have lagged 2007 (refer to figure 13). This is largely due to deteriorating consumer s health/spending. Figure 13. Gauteng Province Monthly Gambling Revenue Growth, (Y-o-Y %) 25.0% 22.9% Figure 12. Provincial Casino Market Share 20.0% 18.2% 20.7% 19.9% Gauteng 41% Western Cape 18% KZN 17% Limpopo 2% 15.0% 13.7% 14.8% 13.1% 16.0% Free State 3% Eastern Cape 8% Mpumalanga 4% North West 6% Nothern Cape 1% 10.0% 5.0% 7.2% 4.9% 4.7% 8.6% 6.5% 6.1% Source: Citi Investment Research and CASA 0.0% Jan Feb Mar Apr May Jun Jul Source: Citi Investment Research and Gauteng Gambling Board Gauteng accounts for c41% share of total casino gambling revenues, Western Cape 18%, and KZN 17%. Kwazulu-Natal province 10 is also experiencing a similar slowdown in revenue growth. YTD, revenues are up only 6% (refer to figure 14). In the Western Cape Province 11, GGR for the March to June 2008 period showed a meagre 5.2% growth (refer to figure 15). 9 Gauteng accounts for c40% market share in South Africa 10 Kwazulu-Natal accounts for 17% of national gambling revenues 11 Western Cape Province accounts for 18% of national gambling revenues 12

13 Figure 14. Kwazulu-Natal Province - Monthly Gambling Revenue Growth Figure 15. Western Cape Province Monthly Gambling Revenue Growth 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% -2.0% Jan-08 Feb-08 Mar-08 Apr-08 May-08 Jun % 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% Mar-08 Apr-08 May-08 Jun-08 GGR growth GGR Growth Source: Citi Investment Research, KZN Gambling Board Source: Citi Investment Research and Western Cape Gambling Board Health of the Consumer At a Glance Total Household Debt to Disposable Income Household debt to income ratio at 78.2% in 1Q08 Household debt/income ratios have risen over time, currently at 78.2%, this suggests a greater sensitivity of income and hence spending to interest rate shifts. Given the current rising interest rate cycle, higher debt ratios should result in higher debt servicing costs for the household. We now look at the relationship between debt servicing costs and prime interest rates to understand this aspect, refer to figure 17. Debt-service cost as a percentage of disposable income ratio is just below the 12% level. It has been rising in line with inflation. Figure 16. Household Debt to Disposable Income Figure 17. Debt Servicing costs as a % of Disposable Income and Prime Interest rates Mar-69 Mar-72 Mar-75 Mar-78 Mar-81 Mar-84 Mar-87 Mar-90 Mar-93 Mar-96 Mar-99 Mar-02 Mar-05 Mar-08 % Source: Citi Investment Research and Inet Source: Citi Investment Research and Inet 13

14 Figure 18. Household Disposable Income growth 30% 25% 20% 15% 10% Disposable income Key Driver of Gross Gambling Revenue (GGR) As depicted figure 18, alongside, it is apparent that disposable income only showed a 9% increase in the first quarter of 2008, well below the 13% average growth in This figure would probably remain under pressure in the medium term, largely due to higher inflation and interest rate environment in South Africa. 5% 0% Mar-90 Sep-90 Mar-91 Sep-91 Mar-92 Sep-92 Mar-93 Sep-93 Mar-94 Sep-94 Mar-95 Sep-95 Mar-96 Sep-96 Mar-97 Sep-97 Mar-98 Sep-98 Mar-99 Sep-99 Mar-00 Sep-00 Mar-01 Sep-01 Mar-02 Sep-02 Mar-03 Sep-03 Mar-04 Sep-04 Mar-05 Sep-05 Mar-06 Sep-06 Mar-07 Sep-07 Mar-08 Generally, casinos depend on tourism and leisure travel, which are directly affected by personal incomes and thus the status of the economy. Source: Citi Investment Research and I-net FNB/BER Consumer Confidence Index (CCI) The Consumer confidence index fell by 18 points in 2Q08 to -6, the weakest reading since Confidence is still far from historical lows of -33 the 2Q reading is about one standard deviation below the long-term mean but it is falling sharply. The 2Q drop was the largest since 4Q84, and the cumulative two-quarter drop (28 points) also the second largest since that year. The latest data released by FNB/BER on consumer confidence confirms the consumer gloom in South Africa. The split of the CCI showed a marked decline in household opinion on the economy in general and personal finances, and a lesser 10-point decline in intentions to buy durable goods. Furthermore, the survey showed that unlike in earlier quarters, when it had been much more resilient, confidence of black consumers fell by a larger amount than that of whites (-20, versus -14). The consumer confidence can also be looked at in conjunction with retail sales, which have also remained under a lot of pressure. Figure 19. FNB/BER Consumer Confidence Index Jun-82 Jun-84 Jun-86 Jun-88 Jun-90 Jun-92 Jun-94 Jun-96 Jun-98 Jun-00 Jun-02 Jun-04 Jun-06 Jun Consumer Confidence 3 per. Mov. Avg. (Consumer Confidence) Source: Citi Investment Research and I-Net 14

15 Implications Consumer mood at a four-year low According to our economist 12, this data reinforces the house expectations of a further consumer-driven economic slowdown in coming quarters. We look for average HCE 13 growth of 3.2 % this year, in part because of the carry-over from last year, but of only 1.7% in Household consumption spending would likely remain under severe pressure as a result of cumulative effect of interest rate rises, inflationary pressures, high levels of personal debt, and a slowdown of economic activity. Consumer Spend on Gambling Gambling has generally gained popularity in the past as most of the casinos were built, particularly in metropolitan areas. As a result, spending on different types of gambling modes has increased (see figure 20 below) Figure 20. Gambling Spend in South Africa [Rand Million] Casino Gambling Lottery Horse Racing LPM Bingo TOTAL Source: Citi Investment Research and Casino Association of South Africa Propensity to gamble Propensity to gamble is defined as the percentage of household expenditure allocated to gambling. This is calculated at 1.39% for 2007 and amounts to a total of R11.7bn spent on casino gambling. We have also done an analysis dating back to 2003 and note that the ratio has been on an upward trend. Medium-term outlook: Our view is that the ratio should probably come under pressure, mainly due to the consumer-driven economic slowdown, as discussed earlier. 12 Jean-Francois Mercier ( ) 13 Household Consumption Expenditure 15

16 Figure 21. Marginal Propensity to Gamble (Casino) 1.4% 1.2% 1.0% 0.8% Source: Citi Investment Research, Casino Survey and Inet Wagering in an Economic Slowdown The impact of rising rates on leisure stocks It is known that gaming stocks and the industry as a whole is highly free cash flow generative, which is a key leading performance indicator going into an economic slowdown. We look at how the stocks actually perform ahead of, and during, a rising rate cycle. The longest time period we were able to assess extended back to September 1994, so we evaluated the last four rising rate cycles (including the current one). Interest rates in South Africa have been on a rising cycle since June 2006, rising by a cumulative 500 basis points to date. Higher rates should result in lower disposable income as household services its debt 14. In this section, we look at the previous rising rate cycles and its impact on the listed leisure share prices. Our overall view is that during the rising rate cycles, travel, leisure & entertainment 15 stock prices generally underperform the overall market. Figure 22 below summarises the eight rising rate cycles since Household debt to disposable income is around 80% in South Africa 15 Leisure sector includes Sun International, Gold Reef (listed in late 1999), City Lodge, Phumelela, Tourvest, Famousbrands, and Comair 16

17 Figure 22. Summary of rising rate cycles since 1970 Rising Rate Cycles Duration (Months) Prime before Prime after Change in Nominal rates Sep July % 9.0% 1.0% Nov July % 12.5% 5.0% Jan Sep % 20.0% 10.5% Jun Apr % 25.0% 11.0% Jan Feb % 21.0% 8.5% Sep Sep % 20.3% 5.0% Jun Sep % 25.5% 7.3% Jan May % 17.5% 4.0% Jun August % 15.5% 5.0% (current) Source: Citi Investment Research and Inet We now look at the performance of leisure stocks relative to the FINDI (Financial and Industrial Index), as it primarily includes the interest ratesensitive stocks. We also look at the PE relatives over the different rising rate cycles. Sep 1994 Sep 1997 cycle Figure 23. The September 1994 September 1997 Cycle (based on closing Prices) Figure 24. The September 1994 September 1997 Cycle (based on PE ratios) 21 % % Jun Aug Oct Dec Feb Apr Jun Aug Oct Dec Feb Apr Jun Aug Oct Dec Feb Apr Jun Aug Oct Jun Aug Oct Dec Feb Apr Jun Aug Oct Dec Feb Apr Jun Aug Oct Dec Feb Apr Jun Aug Oct-97 Prime rate [LHS] Leisure relative to FINDI [RHS] Prime rate [LHS] Leisure PE rel All-share [RHS] Source: Citi Investment Research and I-net Source: Citi Investment Research and I-net Key take-away points: 1. Leisure stocks outperformed the FINDI during the rising rate cycle. 2. Generally leisure stocks tend to underperform at the end of the rising rate cycle. As depicted on figure 23 above, the stocks started underperforming after the rates had peaked. 3. After rates had peaked, leisure underperformed for seven months before outperforming the FINDI after the first rate cut. 17

18 June Sep 1998 cycle Figure 25. The June 1998 September 1998 Cycle (based on closing prices) Figure 26. The June 1998 September 1998 Cycle (based on PE ratios) 26 % % Feb Feb Feb-98 1-Mar-98 8-Mar Mar Mar Mar-98 5-Apr Apr Apr Apr-98 3-May May May May May-98 7-Jun Jun Jun Jun-98 5-Jul Jul Jul Jul-98 2-Aug-98 9-Aug Aug Aug Aug-98 6-Sep Sep Sep Sep-98 4-Oct Oct Oct Oct-98 1-Nov-98 8-Nov Feb-98 8-Mar Mar-98 5-Apr Apr-98 3-May May May Jun Jun Jul Jul-98 9-Aug Aug-98 6-Sep Sep-98 4-Oct Oct-98 1-Nov-98 Prime rate [LHS] Leisure relative to FINDI [RHS] Prime rate [LHS] Leisure PE rel All-share [RHS] Source: Citi Investment Research and Inet Source: Citi Investment Research and Inet Key take-away points: 1. Leisure stocks underperformed the FINDI during the rising rate cycle, despite the cycle being short (3 months only) 2. After the rates had peaked, the leisure stocks continued to underperform. 3. The underperformance continued even after the first cut. This could have been due to an overall bigger nominal change in rates (7.3%). January 2002 May 2003 Cycle Figure 27. The January 2002 May 2003 Cycle (based on closing prices) Figure 28. The January 2002 May 2003 Cycle (based on PE ratios) % % Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Jan Feb Feb Mar Mar-02 7-Apr Apr-02 5-May May-02 2-Jun Jun Jun Jul Jul Aug Aug-02 8-Sep Sep-02 6-Oct Oct-02 3-Nov Nov-02 1-Dec Dec Dec Jan Jan-03 9-Feb Feb-03 Prime rate [LHS] Leisure relative to FINDI [RHS] Prime rate [LHS] Leisure PE rel All-share [RHS] Source: Citi Investment Research and Inet Source: Citi Investment Research and Inet 18

19 Key take-away points: 1. As has been the trend in the past, leisure stocks outperformed during the rising rate cycle, but underperformed slightly after rates had peaked. 2. The underperformance was minimised during this cycle. Furthermore, it only lasted for four months, compared to seven months in the last cycle. 3. Our view is that over this period, share prices were driven by the opening of new casinos, which provided an impetus to earnings growth. Some of the casinos that were opened during this period included GrandWest Casino Dec 2001, Sibaya Resorts Feb 2001, Golden horse casino Sep 2001, Flamingo Casino Mar 2002, Garden Route Casino Dec Stocks started outperforming soon there-after, probably in anticipation of 1) the decline in rates and 2) the positive impact emanating from new casinos. June 2006 August 2008 Cycle (Current) Figure 29. The June 2006 Current Cycle (based on closing prices) Figure 30. The June 2006 Current Cycle (based on PE ratios) 16 % % Jan-06 8-Feb-06 8-Mar-06 8-Apr-06 8-May-06 8-Jun-06 8-Jul-06 8-Aug-06 8-Sep-06 8-Oct-06 8-Nov-06 8-Dec-06 8-Jan-07 8-Feb-07 8-Mar-07 8-Apr-07 8-May-07 8-Jun-07 8-Jul-07 8-Aug-07 8-Sep-07 8-Oct-07 8-Nov-07 8-Dec-07 8-Jan-08 8-Feb-08 8-Mar-08 8-Apr-08 8-May-08 8-Jun-08 8-Jul-08 8-Jan-06 8-Feb-06 8-Mar-06 8-Apr-06 8-May-06 8-Jun-06 8-Jul-06 8-Aug-06 8-Sep-06 8-Oct-06 8-Nov-06 8-Dec-06 8-Jan-07 8-Feb-07 8-Mar-07 8-Apr-07 8-May-07 8-Jun-07 8-Jul-07 8-Aug-07 8-Sep-07 8-Oct-07 8-Nov-07 8-Dec-07 8-Jan-08 8-Feb-08 8-Mar-08 8-Apr-08 8-May-08 8-Jun-08 8-Jul-08 8-Aug-08 Prime rate [LHS] Leisure relative to FINDI [RHS] Prime rate [LHS] Leisure PE rel All-share [RHS] Source: Citi Investment Research and Inet Source: Citi Investment Research and Inet Key take-away points: 1. As was the case in the prior rising rate cycles, leisure stocks outperformed during the early stages of the rising rate cycles. 2. But in this cycle, the outperformance was cut short after the 5 th rate hike as it appeared that the inflation figures were deteriorating and indicated that rates were going to increase further. 3. The underperformance started in May 2007, and has been more severe in this cycle. 4. Leisure stocks did, however, start outperforming slightly at about the time of the October 2007 rate hike. The market probably thought that the end of the rising rate cycle was in sight. There was one more rate hike in December 2007 and then the SARB paused. 19

20 5. Leisure stocks started underperforming again after January 2008 as higher-than-expected inflation numbers were again released and it became clear that more hikes were going to be needed. Leisure stocks have pretty much consistently underperformed the FINDI ever since. 6. The household debt/income ratios have risen over time, suggesting a greater sensitivity of income and hence spending to interest rate shifts. Bottom line: Given that in the prior cycles that we have looked at leisure stocks underperformed once rates had peaked 16. The underperformance duration varied in the prior cycles from 4 months to 7 months after rates had peaked. Our view is that rates have peaked and are expected to start declining by June Where are we relative to historical lows? The share prices of the two listed gaming licence holders in South Africa were pummeled in the first half of Sun International and Gold Reef underperformed the JSE All-Share Index by 47% and 59%, respectively, over this period. Understandably so, as the All Share Index was pushed higher on the back of resource counters given the higher commodity prices. We pulled historical PEs for Sun International, Gold Reef and City Lodge from the data stream and focused on the lowest PE level ever reached. We applied the trough PE to our current FY09e EPS to get an implied trough share price. According to our analysis, the companies that we analyse appear to be most expensive relative to their historical valuations. However, this time it is different, as more casino have opened since early Figure E PE vs. Historical trough PE Historical Trough 2009 EPS Implied Trough Current Price Current CY08 PE Downside PE* Price City Lodge % Gold Reef % Sun International % HCI** % The Don Group 4.8 n/a n/a n/a n/a n/a Tourvest 3.0 n/a n/a n/a n/a n/a Source: Citi Investment Research, Inet, Priced as at 15 August 2008 *We used 1998 trough PE when the interest rates in South Africa reached a record high of over 25% **We do not cover Hosken Investment Holdings (HCI), we use I-net consensus estimates where appropriate 16 Although in one of these cases (January 2002 May 2003 cycle) the underperformance was muted 20

21 How far could share prices go? Given that hotel & leisure share prices have come under immense pressure lately, we look at the current share price relative to its most recent peak in order to assess the magnitude of the recent sell-off and also the potential upside risk. Upside to recent highs Below we show the stocks upside relative to their recent highs. We note that Gold Reef offers the highest upside ranking, but also highlight that Gold Reef shares rallied on the back of a take-out offer by Ethos, which failed. Figure 32. Upside to 2007 peak Gold Reef Sun International HCI City Lodge 0% 20% 40% 60% 80% 100% 120% 140% Source: Citi Investment Research, Inet, Priced as at 15 Aug 2008 Cannibalisation in the Gauteng Province The combination of the size of Gauteng s population and its high propensity to gamble makes the province the most lucrative market in South Africa. According to the casino association in South Africa (CASA), it is estimated that Gauteng captures over 40% of the South African casino gambling market (refer to figure 33 below). 21

22 Figure 33. Provincial Casino Market Share Western Cape 18% Gauteng 41% KZN 17% Limpopo 2% Mpumalanga 4% Free State 3% Eastern Cape 8% North West 6% Nothern Cape 1% Source: Citi Investment Research and CASA We believe that given the sheer magnitude of Gauteng gambling revenues versus other provinces, it has attracted a lot of interest from other industry players. Currently, there are seven licenses operational in Gauteng, the last one to open in December 2007 being Silverstar casino (owned by Gold Reef Resorts). Due to the close proximity of the seven casinos, Gauteng is experiencing the highest degree of competition for punters. The emergence of new competition in Gauteng could pose longer-term challenges to EBITDA margins as different players spend more money on marketing and promotion in order to attract punters to their properties. In the figure below, we calculate the distance travelled between all the cities in Gauteng where casinos are operational. Our conclusion is that all the cities within close proximity (i.e. kilometres below 30) are likely to be affected by cannibalisation. They include Silverstar casino 17 (Gold Reef), Montecasino 18 (Tsogo Sun gaming), Emperors Palace 19 (Peermont casino), and Gold Reef City Casino 20. Is Sun International affected by Cannibalisation? Bottom line: We highlight that Sun International is unlikely to be affected by cannibalisation, given its scattered geographic footprint in the Gauteng province. To make the reading of the table below easier, we have also provided a chart that shows the location of all the casinos in South Africa on page Krugersdorp 18 Fourways 19 Kempton Park 20 Johannesburg 22

23 Figure 34. Distance travelled between different cities in Gauteng (km) Johannesburg (Gold Reef Casino) Krugersdorp (Silverstar Casino) Fourways (Montecasino) Mabopane (Morula Sun) Brakpan (Carnival City) Vanderbijlpark (Emerald Casino) Kempton Park (Emperors Palace) Johannesburg (Gold Reef Casino) Krugersdorp (Silverstar Casino) Fourways (Montecasino) Mabopane (Morula Sun) Brakpan (Carnival City) Vanderbijlpark (Emerald Casino) Kempton Park (Emperors Palace) Source: Citi Investment Research Figure 35. Gauteng Casinos EBITDA margins, FY07 EBITDA margins Emperors Palace 40.4% Gold Reef City 38.0% Carnival City 36.7% Silverstar Casino 30.8% Morula Sun 24.2% Source: Citi Investment Research and Co reports Interestingly enough, cannibalisation is seen across both punters as well as management/staff. Frontier Inn Casino (owned by Peermont) indicated in its recent results (1Q08) that it was negatively affected by the poaching of table staff and management 21 for the newly opened Silverstar casino. Given this high degree of competition in the Gauteng province, we also observe that margins are low when compared to other provinces (see table alongside). Emperors Palace (owned by Peermont) appears to boast better margins than its listed peers in the table alongside. The Western Cape and Kwazulu-Natal offes probably the highest EBITDA margins (refer to Appendix A, which illustrates margins for majority of the casinos in South Africa). Growing casino market share successfully in Gauteng will lie in management s ability to get the right balance between percentage win and visitor volumes i.e. maximizing casino win without losing patrons and gaming spend. The close proximity of Gauteng casinos should complicate this task though. Operating Leverage Analysis In this section, we explore the relationship between revenue growth and operating profit growth for the two casino companies listed on the JSE. Figure 36. Degree of Operating Leverage Formula Source: Citi Investment Research and Wikipedia Methodology: We define operating leverage as the percentage growth in operating profit resulting from a percentage point increase in revenues (see figure alongside). In the analysis that follows, we have analysed historical revenue growth on operating profit growth to determine the degree of operating leverage. In some cases, we have excluded a few extreme outliers in the data to achieve a tighter fit. The results enable investors to quickly identify and quantify where operating leverage is relatively high and low, and to also determine where operating leverage is changing, a potential symptom of secular changes. High operating leverage can cut both ways, driving aboveaverage profit growth and upward estimate revisions when times are good and the inverse when times are not so good. Our database consists of two listed casino companies in South Africa (Sun International & Gold Reef Resorts). We also look at Peermont, which is privately held, but discloses its results on a quarterly basis. We also attempt to look at Tsogo Sun gaming 22 figures. 21 Staff is willing to relocate to Krugersdorp, as Silverstar is situated in the urban part of the province. 22 Tsogo Sun Gaming reports under HCI. It is 51% held by Tsogo Investment Holding Company and 49% by SABMiller 23

24 Figure 37. South African Casinos Operating Leverage Sun Intl Gold Reef Peermont* FY00 (5.93) n/a n/a FY n/a n/a FY n/a 0.09 FY FY FY FY FY FY08e n/a Source: Citi Investment Research and company reports *De-listed on the stock exchange Key take-aways from the figure 37 above: Of all the casino companies, Sun International appears to be more leveraged (i.e. during good times, it performs better). A key question is what happens when the economic situation changes? According to the survey, Gold Reef appears less leveraged to the economic cycle. In the following section below, we attempt to look at operating leverage across global casino companies in different countries. Key take-aways from figure 38: US and United Kingdom: Performance appears quite mixed, with different companies reporting mixed results. Europe: It appears that casinos in Europe are likely to experience margin squeeze (i.e. expected leverage below 1x). Asia: Companies in Asia are performing relatively well, particularly Melco Entertainment. This is probably driven by the Macau gaming market, which is experience healthy growth. Australia: Australian companies appear better positioned (particularly Crown) due to medium-term growth expectations from both its hotel and casino renovation. International growth should also be delivered from development and opening of the pipeline of international projects. Bottom line: South African stocks are likely to experience lower leverage, given a general slowdown in revenue growth. As indicated before, casinos are broadly a high fixed cost business. We calculate an expected average operating leverage of 0.7x (indicative of margin compression in FY08). 24

25 Figure 38. Revenue and Operating Profit Growth Expected Results Growth & Leverage - Expected Results Incremental Operating Income growth per % of revenue growth Percentage Revenue growth Percentage Profit growth South Africa Casinos Sun International % 5.8% Gold Reef Resorts % 17.5% Peermont* % 16.1% Average % 13.1% US Casinos MGM Mirage Inc % -54.8% Las Vegas Sands Corp % 24.5% Wynn Resorts LTD (0.1) 18.0% -1.2% Boyd Gaming Corp % -50.9% Melco Crown Entertainment (0.4) 336.0% % Average 6.5 UK Casinos Rank Group PLC % % William Hill PLC (1.2) 5.0% -5.8% Ladbrokes Plc % -38.4% 11.1 Europe Casinos Intralot SA % 10.7% OPAP SA % 24.7% Berjaya Sports Toto (0.7) 8.0% -5.8% Lottomatica Spa % 12.0% Average 0.4 Asia Casinos REXCAPITAL Financial Holdings % 488.6% China LotSynergy % -54.8% Melco % -26.6% Galaxy Entertainment (5.4) -21.5% 115.9% Average (0.0) Australian Casinos Crown Ltd % 3.0% TABCORP Holdings Ltd % 12.6% Tatts Group Ltd % 30.7% Sky City Entertainment Group Ltd % 3.8% Source: Powered by datacentral *We use historic data for Peermont and highlight that the company is no longer listed on the JSE Stock Exchange 25

26 Private Equity in the Leisure Sector There have been a number of private equity transactions in the market across the board. Recently announced transactions include, amongst others, Peermont Global Resort, which was taken over by a consortium led by the Mineworkers Investment Company (MIC) in a deal valued at R7bn in In a recent deal (which lapsed), Gold Reef indicated that a consortium known as Bidco (including South African private equity firm Ethos Private Equity and Goldman Sachs) would pay R34 per share for Gold Reef Resorts. The deal fell through after it failed to get the approval from the various gambling boards. According to SRP, Gold Reef had contravened four rules around securities regulations. Attractiveness of the South African market as a private equity market: A liquid and transparent stock market to enable private equity players to easily cash out their investments. High profitability. High cash flow generation to service increased debt levels. Low initial debt levels that can be geared up by private equity funds. A structural underpin that can justify rising company valuations. A market with relatively low valuation levels. 26

27 Sun International Limited 27

28 Sun International Figure 39 and 40 below gives a breakdown of revenue and cost structure for Sun International Holdings Limited. Figure 39. Sun International Revenue Breakdown, FY07a Figure 40. Sun International Cost Breakdown, FY07a Rooms 11% Food & Bev 7% Other 5% Other operational costs Property costs 9% 4% Property and equipment rental 1% Employee costs 27% Tables 11% Slots 66% Consumables and services 14% Promotional and marketing costs 12% Depreciation and amortisation 10% Levies and VAT on casino revenues 23% Source: Citi Investment Research and Company reports Source: Citi Investment Research and company reports Investment Case Gaming fundamentals softening, but Hotels and New Ventures are set to benefit the group in the medium term Figure 41. Sun International s Provincial Market Share 2007 Eastern Cape 72.0% Free State 60.0% Gauteng 22.0% Kwazulu Natal 35.0% Limpopo 87.0% Mpumalanga 0.0% North West 70.0% Northern Cape 88.0% Western Cape 81.0% Source: Company reports and CIR The investment case is very simple for a company that has more than 40% market share in the South African Casino gambling market. While over the short term it is hard to be too optimistic on the outlook for gambling revenues, Sun International is expected to generate 25% (FY08e FY11e) CAGR growth in earnings, driven by 1) new developments in other markets, which we view as positive, and 2) the hotel business, which remains buoyant. Currently Sun Int l trades at a trailing P/E multiple of 12.7x and a twelve-month rolling forward PE of 10x (on our estimates), below the ALSI forward PE of around 11x (on consensus estimates). At current share price levels, Sun International offers a good entry point to gain exposure to its strong cash flow returns and resilient hotel business. We initiate coverage with a Buy/Medium (1M) risk and a target price of R Sun International maintains dominant market share Sun International has the highest casino market share (43%) in South Africa. In total, Sun International owns/operates 13 casinos. The company s size and scale allows for a large research and a development budget versus its peers, greater product breadth, and a large marketing and promotions budget 23. Overall, the company is well positioned to maximise entertainment value through its customer loyalty programmes. Sun International s annual promotion and marketing spend of R577 in FY07 is on average more than four times that of its peers. A portfolio of attractive assets Sun International offers exposure to attractive assets (i.e. GrandWest, Sun City, Carnival City, Sibaya and Boardwalk) arguably five of the most dynamic gaming markets in South Africa and the biggest casinos by revenue. Through its different properties, Sun Int l generates the majority (66%) of its revenues from slots, while 11% is generated from tables. Hotels also contribute around 11%. 23 In an attempt to build on the corporate positioning of Sun International, an idea came up to use Oscar winner Charlize Theron as a star in a TV advert, which hit the screens in April This explains the size and scale that allows for a bigger budget. 28

29 New markets Sun International should benefit from its initiative to venture into new markets (Nigeria and Chile) 24. Our view is that, long-term, the new initiatives in areas outside of South Africa should result in a re-rating. We do not expect any meaningful contribution in FY08, but in FY09 at the earliest. We therefore believe that when these new developments come to market, earnings should replace cost. Overall, we are positive on these new projects. Figure 42. Sun International FCF (FY03a FY10e) FY03a FY04a FY05a FY06a FY07a FY08e FY09e FY010e FCF FCF Yield Source: Citi Investment Research and Co reports Figure 43. Sun International - EBITDA Margins 40.0% 30.0% 20.0% 10.0% 0.0% 18.0% 16.0% 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% FY02A FY03A FY04A FY05A FY06A FY07A FY08E FY09E FY10E Source: Citi Investment Research and Co reports Strong Cash Flows Over the years the group, in its current format, has generated an average free cash flow of around R519 million per annum (R900 million in FY07). This translates to around 7.5% of revenues, or c. 27% of operating profits. This means that despite risks from slowing consumption expenditure in South Africa, the company has a firm balance sheet and tends to generate enough cash to constantly grow its business. Although Sun is cash generative, we highlight that it has the higher degree of operating leverage 25 (i.e. any slowdown in revenue growth could be magnified into large errors in cash flow projections). The company generates high margins at its casinos. Furthermore, free cash flow is strong but the balance sheet leverage is a bit high, leaving no room for further share repurchases. Expected market share dilution in Gauteng The opening of Silver Star Casino 26 is likely to result in market share dilution, in the event of the pie not growing. We estimate that in its first weeks of operation, Silver Star recorded market share of between 8% and 9%. Gold Reef Management indicated that it is targeting 10% market share. The close proximity of Gauteng casinos should make trading quite difficult as cannibalisation takes its toll. Companies with greater product breadth, as well as a large marketing and promotion budget, (Sun International) should do well in the race. Inevitable margin squeeze Given the meaningful slowdown expected in gaming revenues, we would expect operating margins to be under pressure in FY08e. Casinos are generally of high fixed cost base nature. Operating leverage The higher the degree of operating leverage; the greater the potential danger from forecasting risk. That is, if a relatively small error is made in forecasting sales, it can be magnified into large errors in cash flow projections. Given Sun International s high operating leverage, we would expect significant margin squeeze and a resultant negative cash flow impact. Catalyst Despite there being no short-term catalyst for Sun International, we highlight that its exposure to the hotel business (c. 11% of revenues), which remains buoyant, and also the new developments in Nigeria, Chile and should add the impetus to earnings growth. In addition, the share price has declined by c. 40%, YTD, which makes it even more attractive at these levels. We believe that the recent underperformance since mid-2007 has been driven by the consumer-related concerns (i.e. lower disposable income amidst higher inflation and higher interests) and a general de-rating in the market. However, we think the market now fully discounts a weaker household consumption environment. We therefore initiate coverage with a Buy/Medium risk recommendation. 24 These are discussed from page Refer to page 18 for a detailed analysis on operating leverage analysis 26 Owned by Gold Reef Resorts Casinos 29

30 Figure 44. EPS and DPS (FY04 FY10e) Cents per share 1, , % EPS CAGR FY04A FY05A FY06A FY07A FY08E FY09E FY10E EPS DPS Source: Citi Investment Research and Co reports Industry risks While there are valid concerns over a general slowdown 27 in South African gambling revenues and inevitable margin pressures, we believe that new developments and an excellent product offering make the company s more attractive. Earnings outlook Our earnings estimates for FY08e FY10e are R6.72, R8.40, R10.71, respectively. Our FY08e estimate of R6.72 (down 6% on the prior year) is slightly below consensus estimates of R6.77. Earnings are negatively affected by higher interest charges due to higher gearing. Valuation Our valuation is based on a sum-of-the-parts basis, after discounting all the cash flows for all the casinos (using discounted cash flow methodology). Our view is that this methodology is sufficient in order to capture the value of all the casinos wholly and partially owned by Sun International. We derive a fair value of R109.00, which we set as our target price. The main assumptions in our casino DCF valuation are beta of 1x, risk free rate of 9.2%, and an equity risk premium of 5%. We use a discount rate of around 11.2%. Refer to the following section for our detailed valuation methodology. Historical Share Price Performance Since the peak of the market in May 2008, the JSE All Share Index has fallen by some 14% to date. Sun International reached a high of R in June The share price has since remained under pressure. We believe that the share price underperformance has been driven largely by the consumer-related concerns (i.e. lower disposable income amidst higher inflation and higher interest rates) and a general de-rating in the market. However, we think the market now fully discounts a weaker household consumption environment and omits Sun International s resilient hotel business operations and the potential of new markets (i.e Chile and Nigeria). 27 Due a slowdown in household disposable income 30

31 Figure 45. Sun International Historical Share Price Performance ( ) Earnings declined 10% on prior year City Lodge disposal gain of 627 m Kersaf to sell Sun Intl shares worth $54m Sun announces profit decline of 55% and no Kersaf EBITDA rises 30% Net profit surged to 86m ZAR from 18m the year earlier First half profit expected to surge up Sun announces that fiscal 2003 profit rose almost First half profit more than doubled Sun sells 30% stake inwild Coast to empowerment group Sun expresses interest in acquiring Real Africa Holdings Disposal of 38.6% stake in City Lodge for 627m ZAR Sun announces Chile casino development 7% Sales rise on increase in Hotel visitors 3-Dec-00 3-Mar-01 3-Jun-01 3-Sep-01 3-Dec-01 3-Mar-02 3-Jun-02 3-Sep-02 3-Dec-02 3-Mar-03 3-Jun-03 3-Sep-03 3-Dec-03 3-Mar-04 3-Jun-04 3-Sep-04 3-Dec-04 3-Mar-05 3-Jun-05 3-Sep-05 3-Dec-05 3-Mar-06 3-Jun-06 3-Sep-06 3-Dec-06 3-Mar-07 3-Jun-07 3-Sep-07 3-Dec-07 3-Mar-08 3-Jun SUI SUI/J203 Source: Citi Investment Research, I-net Bridge and Bloomberg Valuation and Risks Valuation Valuation Methodology We employ both absolute and relative valuation metrics to derive an equity value for Sun International. However, an absolute metric based on a fundamental SoTP DCF analysis is our favoured approach as it captures the value of all the casinos wholly and partially owned by Sun International. We also cross check our fundamental analysis with PE relative valuation multiple, and lastly we apply the Dividend Discount Model. Sum of the Parts (SoTP) based on Discounted Cash Flow (DCF) Sun International offers a reasonable level of breakdown of divisional profitability in its financial statements. We have therefore modelled the company on a casino-by-casino basis, as opposed to the typical valuation methodology, which looks at the group from the basis of group revenues downwards. Our valuation is based on a sum-of-the-parts basis, after discounting all the cash flows for all the casinos (using discounted cash flow). Our view is that this methodology is sufficient in order to capture the value of all the casinos wholly and partially owned by Sun International. 31

32 We derive a value per share of R109, which we set as our twelve-month target price. Our sum-of-the-parts valuation methodology implies a blended 2009e EBITDA multiple of 6.4x. Our sum-of-the-parts is presented below. Figure 46. Sun International Sum-of-the-parts Valuation Analysis (Based on DCF) [Rand Millions] EBITDA 2009 Enterprise Value Debt as at Dec 2007 EV ex Debt Ownership % of Value GrandWest ,926.0 (513.0) 5, % 3, % Sun City % % Carnival City ,509.8 (367.0) 2, % 1, % Sibaya ,928.5 (369.0) 1, % % Table Bay % % Boardwalk ,468.2 (191.0) 1, % % Wild Coast % % Carousel % % Morula % % Swaziland % % Botswana % % Meropa (98.0) % % Flamingo (59.0) % % Windmill (18.0) % % Golden Valley (40.0) % % Zambia % % Namibia % % Lesotho % % Nigeria % % Chile , , % % Management Activities , , , % Real Africa Holdings (Mkt price) Total 3, ,970.8 (1,655.0) 19, ,641.8 Total sum of the parts value 13,641.8 Net cash/(debt) at centre (3,203) Total sum of the parts value ex debt 10,438 Shares in Issue 96...Value per share R Current share price R Upside 17% Source: Citi Investment Research The methodology used in our sum-of-the-parts valuation analysis is explained below: Figure 47. WACC Assumptions Cost of debt 9.2% Cost of equity 14.2% Debt ratio 40% Equity ratio 60% WACC 11.2% Source: Citi Investment Research and Co reports Enterprise value: This is calculated using a DCF-based approach. Discount rate of 11.2%: We use a discount rate of 11.2%. This is equal to Sun International s estimated Weighted Average Cost of Capital. Assumptions are provided on the figure alongside. The main assumptions in our casino DCF valuation are beta of 1x, risk free rate of 9.2%, and an equity risk premium of 5%. Long-term growth: We applied a long-term growth of 6% Implied Valuation multiple of 6.1x: We note that our valuation analysis implied an EBITDA multiple based on EV of 6.1x for the next 12 months. This is still at a considerable discount to Sun International s peers globally, but in line with its three-year historic multiple. 32

33 What if Upside Benchmarking Sun International with global peers As indicated in our DCF-based SoTP valuation methodology above, the implied EV/EBITDA multiple is 6.1x for the next 12 months. Methodology: In the what if or benchmark valuation scenario, we use our FY09e EBITDA forecasts for the group and apply average EV/EBITDA ratios in different countries in our global peer sample to derive the enterprise value. Overall, we forecast FY09e EBITDA of R3,1bn for Sun International. Applying different multiples to our EBITDA, we derive enterprise value in all five scenarios. A key take-away is that when benchmarking Sun International with its peers in US, a value of R compared to our SoTP value of R109 is calculated. Refer to figure 48 below. Figure 48. Sun International Benchmark Valuation [Rand Millions] US UK Europe Asia Australia EBITDA 3, , , , ,116.1 Average EV/EBITDA multiple Enterprice value 31, , , , ,566.1 Net Debt as at Dec 2007 (4,858.39) (4,858.39) (4,858.39) (4,858.39) (4,858.39) EV ex debt 26, , , , ,707.7 Estimated overall ownership 70% 70% 70% 70% 70% 18, , , , ,995.4 Number of shares Value per share R R R R R Our "Base" Case SoTP R R R R R Upside/(downside) to our valuation 80.6% 28.3% 20.0% 61.8% 5.3% Source: Citi Investment Research, Priced as at 15 August 2008 P/E Relative Valuation We analyse the P/E of Sun International relative to the JSE All-Share Index: The JSE/FTSE All Share Index. Sun International is currently trading at a historical PER of 1.3x to the market. However, we use an historic average PER of 1.1x for the valuation purpose. The PER is calculated from Applying a 1.1x PER to the All-share index exit PE of around 12.5x and 12- month rolling EPS of 869cps, we arrive at a value of R Figure 49. Sun International Relative Valuation SUI Relative Valuation Exit PE SUI PER EPS Value/share Alsi R117.5 Source: Citi Investment Research 33

34 Valuation debate Is 1.1x PER too demanding? Our view is that industry fundamentals determine where the companies should trade, i.e. if the industry prospects are rosy, companies should trade at a premium to its peers and to an extent the market. In the following table 28 we highlight the various ratings of global peers in developed as well as developing markets. Comparisons between consumer companies in different countries are difficult because of varying GDP growth rates and inflation levels. However, we look at these in this section as a reality check on global investor sentiment. The following is the summary of the comparisons (also refer to the figure below). Global perspective US: Generally stocks in the US trade at a premium to the market. We have used the Dow Jones Index as a proxy for the market. UK: On average, UK casino stocks trade at a slight premium to the market. Australia/New Zealand: Aussie stocks trade at an average discount of 20% to the market, with Crown trading in line with the market. Asia: PE relatives for Asian stocks are largely mixed. South Africa: SA stocks have historically traded at a discount to the market. We expect the discount to narrow in the future given strong operational leverage due to high fixed cost base and the current slow-down in revenue growth. 28 A more detailed Global Comparison with key valuation metrics has been relegated to Appendix G 34

35 Figure 50. PER Global Analysis (All the figures are based on calendar years) Gaming Stocks RIC CIR Rating Prices as at 15 Aug Target price Mkt Cap US$ PER '06e PER '07e PER '08e PER '09e EPS 06 EPS 07 EPS 08 EPS 09 US MGM Mirage Inc MGM.US 2H , Las Vegas Sands CoLVS.US 2S , MGM Mirage Inc MGM.US 2H , Wynn Resorts LTD WYNN.US 2H , Boyd Gaming Corp BYD.US 2S , Melco Crown EntertaMPEL.HK 1M , UK Rank Group PLC RNK.GB 1H William Hill PLC WMH.GB 2M , Ladbrokes Plc LAD.GB 2H , ASIA REXCAPITAL Finan 0555.HK 1H China LotSynergy 8161.HK 3H Melco 0200.HK 1M Galaxy Entertainmen0027.HK 2H , Melco Crown EntertaMPEL.HK 1M , AUZ/NZ Crown Ltd CWN.AU 1M , TABCORP Holdings TAH.AU 2M , Tatts Group Ltd TTS.AU 2M , Sky City EntertainmeSKC.NZ 1M , South Africa Sun International LimSUIJ.ZA 1M , Gold Reef Resorts GDFJ.ZA 2M Source: Powered by datacentral, Priced as at 15 Aug 2008 Dividend Discount Model In figure 51 below, we highlight our DDM methodology. We utilize a discount rate which is equal to our weighted average cost of capital (WACC) and a long term growth of 4%. Figure 51. Sun International Dividend Discount Model FY07 FY08e FY09e FY10e FY11e FY12e FY13e FY14e Dividend R Dividend growth -6.7% 25.0% 27.4% 23.5% 23.6% 11.7% 5.2% Period Long term Discounted cash flow WACC 12% Long term growth 4% Valuation R109.8 Source: Citi Investment Research 35

36 Risks We rate Sun International Medium Risk. The risk rating on the stock is derived after consideration of a number of a number of factors. These factors include an assessment of industry-specific risks, financial risk and management risk. In addition, we consider share price volatility, based upon the input of the Citi quantitative research team, as a possible indicator of future stock-specific risk. With regard to Sun International, we would highlight the main risks to the achievement of our target price as: Economic Risk: The casino industry, similar to many other industries, greatly depends on the conditions of the economy. Economic instability yields a scarcity of consumer spending, while in times of economic stability, local government is less likely to legalise casinos or provide more licences (mainly because government is no longer in need of taxes to boost their revenues). Regulations: Regulations (which are often slow in coming) are typically outside the control of management and can have a significant impact on the profitability of a company, both negative and positive. Asset Concentration: Sun International generates c65% of operating profits from four casinos out of thirteen. This degree of concentration could cause earnings volatility. Although we foresee prospects in the gaming industry in South Africa, we highlight that a more diversified asset base would provide superior predictability of earnings. Extensive investment outside of South Africa: Sun International s extensive investment in countries outside of South Africa is likely to result in high forecast risk as information is scant in those particular countries, particularly in Nigeria. Expansion initiative likely to result in cost overruns and delays: The new developments (Chile and Nigeria) are likely to result in cost overruns and delays driven predominantly by the movement in currencies. The delays are also likely to create uncertainty over medium to short term earnings. 36

37 Company Profile and Strategy Company Profile Sun International was incorporated in 1977 and listed on the Johannesburg Stock Exchange in 1985 Sun International has an attractive business model, characterised by dominant market share in an industry with high competitive barriers to entry. Sun International maintains industry-leading market share of circa 43% of the South African Casino Industry. The chart below gives an indication of the revenue split for Sun International; the majority of revenues (c66%) is generated from slots, which generally have high margins. Figure 52. Sun International Group Revenue Breakdown, FY07a Food & Bev 7% Other 5% Rooms 11% Tables 11% Slots 66% Source: Citi Investment Research and Company Reports Strategy Below we discuss Sun International s strategy: South Africa Gaming: Sun International is well represented in South Africa, operating 13 casinos in total. Given that the total number of licenses issued in South Africa is 40, it is unlikely that more licences will be issued in the future. Resorts: The Company is looking at building more hotels in South Africa. Sun International s drive for international expansion has involved establishing a presence in other parts of Africa and South America International Gaming: Sun International has been looking for opportunities across the International markets (i.e. Russia and United Kingdom, although these did not materialise due to a change in regulations). Sun International is currently developing a casino in Chile. 37

38 Sun International s journey So far so good The chart below depicts the activities that transpired since the inception of Sun International. Figure 53. Sun International s Journey so Far GrandWest Casino opens Kersaf acquires 27% Sibaya casino opens Meropa Casino opens SIML for $16.9m Sun International dispose 38.6% stake in CLH BoardWalk Casino opens Meropa C asino opens Sugarmill casino closed Kersaf buys 20% in Sun Int Flamingo Casino opens 30% of Wild C oast Sun sold to community trust Meropa Casino opens Zimbali Lodge sold to IFA group for R76m SUI sells 11.5% of SunWest to GPI SIEST established GrandWest smoking casino opens Sugarmill temporary Casino opens Meropa Casino opens Sun is split from Southern Sun. Sol Kerzner sells Southern Sun stake to SAB and acquires Sun Int through Kersaf Thaba Nchu Sun casino closed Windmill Casino opens Slots operations in Zambia closed David Coutts-Trotter is appointed CE Sun International dispose 38.6% stake in City Lodge 118 Roomed Sibaya Lodge opened (3 star) Sun bought 61.3% of Real Africa Holdings Peter Bacon retires as C E of Sun, David Coutts Trotter Demarcation changes led to Morula Sun moving from North West to Gauteng Golden Valley casino opens 57 new rooms at Carnival City hotel Source: Citi Investment Research and Company reports New Developments Africa and Other Chile Sun International has concluded an agreement with International Group of Gaming & Resorts and Novomatic Group of Companies, the Austria-based gaming manufacturer and operator, to acquire a 40% equity interest in Chilean entity San Francisco Investment SA, which holds a 15-year casino licence in Region IV of Chile. This initiative should benefit from a long-term management and consultancy agreement. The casino should enjoy 70km exclusivity zone, drawing its customers primarily from the cities of Rancagua and Santiago with a total population in excess of six million. The greater Santiago area is the industrial and financial centre of Chile, and accounts for 45% of the country s GDP. Santiago is ranked the 5 th richest city in Latin America. The property will have 1500 slot machines and 80 tables with a hotel, conference and sports facilities, an amphitheatre, retail, tourist information centre, entertainment amenities for families, and a variety of bars and restaurants. 38

39 The other big casino in Chile is Casino Vina del Mar, which is situated 119kms from Santiago and 75 minutes by car from the capital s international airport. Viña has, in total, 1500 slot machines and 90 tables. A table below is a summary of the casinos in Chile. Figure 54. Summary of Casinos in Chile Slots Tables Casino Vina del Mar Casino Coquimbo Casino Iquique Enjoy Pucon Casino & Resort Casino del Lago Casino Puerto Varas Casino de Arica Source: Citi Investment Research and Chilean Casino Association Below we highlight some of the economic forecasts in Chile Figure 55. Key Economic Forecasts Chile e 2008e 2009e Real GDP, % yoy GDP per capita, US$ Population (millions) CPI, % yoy Policy Interest rate, % Source: National sources and Citi Investment Research Nigeria On the back of increasing political stability and economic growth in Nigeria, Sun International has acquired a 49% stake in Nigeria s Federal Palace Hotel Property on Victoria Island for US$38m. The property will be substantially upgraded, adding a casino, conference centre, restaurants and other entertainment spots at an estimated cost of US$120m. The first phase of the hotel (Federal Palace) has undergone a major refurbishment and opened its doors for trading in July The second phase (Federal Palace Tower hotel) is expected to undergo an extensive refurbishment, starting in December The refurbishment could take anything between 18 and 24 months. The plans are to build a casino (500 slots and 24 tables) in the property as well. However, for the time being a temporary casino boasting 300 slots will be built within the Federal palace hotel and open early next year. Below we highlight some of the economic forecasts in Nigeria. Figure 56. Key Economic Forecasts - Nigeria e 2008e 2009e Real GDP, % y-o-y GDP per capita, US$ ,230 1,517 1,862 Population CPI, % y-o-y Policy Interest rate, % Source: National sources and Citi Investment Research 39

40 Real Africa Holdings Sun International bought a 61.3% stake in Real Africa Holdings on 15 September The intention is to increase its stake in the immediate future. Amongst other shareholders in Real Africa Holdings is Grand Parade Investments, which has a 23% stake. Below, we show Real Africa Holding s ownership structure. Figure 57. Real Africa Holdings Shareholder Structure Real Africa Holdings Sun West 14.6% Carnival City 21.6% Sibaya 13.7% BoardWalk 8.1% Source: Citi Investment Research and Company reports 40

41 Sun International Group Structure Figure 58. Sun International Group Structure Sun International South African Operations Other African Operations Carousel 100% Morula 100% Sun City 100% Naledi Sun 100% Carnival City 86% Sibaya 61% Windmill 74% Meropa 71% GrandWest & Table Bay 71% Flamingo 77% Wild Coast Sun 70% Golden Valley Casino 40% Gaborone Sun 80% Letsatsi Casino 80% Marang Casino 80% Menateng Casino 80% Lesotho Sun 47% Maseru Sun 49% Royal Swazi Sun 51% Ezulwini Sun 51% Lugogo Sun 51% Royal Livingstone 100% Zambezi Sun 100% The Boardwalk 78% Emfuleni 78% Kalahari Sands 100% Management Activities SIML* 100% WC Manco 27% Meropa Manco 50% Kimberly Manco 50% Wild Coast Sun Manco 50% Gauteng Manco 38% Emfuleni Manco 35% Afrisun KZN Manco 29% Mangaung Manco 50% Winelands Casino Manco 50% * Sun International Management Limited Source: Citi Investment Research and Company Reports 41

42 Key Revenue Drivers Casino Revenue Drivers Number of slots This is a function of new slots introduced as well as new casinos licenses being acquired. However, given the fact that Sun International is already well represented in South Africa, we see little room for growth with regards to new licences in the country. Recently Sun International increased its number of slots installed at GrandWest from 1,760 to 2,500. Figure 59. Weighted average number of slot machines FY02 FY03 FY04 FY05 FY06 FY07 Weighted ave number of slots % increase -0.1% -1.2% -3.4% 2.5% 6.1% Source: Citi Investment Research and company reports Win per slot per month Win per slot per month has been increasing; below we show the trend since It is difficult to accurately forecast initial earnings at new casinos, as well as the dilution in win per position that existing casinos will likely experience as new supply is absorbed. Figure 60. Win per slot per month [Rand Million] FY04 FY05 FY06 FY07 Win per slot per month % increase 23% 16% 11% Source: Citi Investment Research and Co reports Number of tables This is a function of new tables being introduced as well as new casino licenses being acquired. However, given the fact that Sun International is already well represented in South Africa, we see little room for growth with regards to new licenses in the country. Growth will be sought globally. Figure 61. Weighted average number of tables FY02 FY03 FY04 FY05 FY06 FY07 Number of tables % increase -1.5% -1.8% -0.6% 1.9% 1.2% Source: Citi Investment Research and company reports 42

43 Win per table per month This number is pretty volatile and difficult to forecast. We note that in FY06, the figure increased by 76% and in FY07 it declined by some 28%. Figure 62. Win per table per month [Rand Million] FY04 FY05 FY06 FY07 Win per table per month % increase 15.2% 75.5% -28.3% Source: Citi Investment Research and company reports Casino Revenue Forecasts We forecast overall casino revenue growth of 9.3% in FY08e. Casino revenue growth is expected to remain sluggish in South Africa, given a general slowdown in household disposable income. For FY09 and FY10e, we are looking for an average revenue growth of 15%, aided by growth from the new developments. Our models suggest that Nigeria should contribute around R350m to revenues in FY08e. Chile is expected to contribute to revenues only in FY09e. Figure 63. Sun International Casino Revenue [Rand Million] FY05A FY06A FY07A FY08E FY09E FY10E Casino Revenue 3, , , , , ,651.4 Growth 18.3% 17.8% 18.0% 7.0% 18.4% 12.7% Source: Citi Investment Research and company reports Hotel Revenue Drivers Room revenue Room revenues contribute 11.2% to group revenues. We identify key revenue drivers for Sun International: 1. Average Room Rates (ARR) 2. Occupancies 3. Room Supply 4. Food & Beverage We discuss these drivers below: 43

44 1. ARR Growing demand in accommodation has generally helped hoteliers to increase average room rates above inflation. Figure 64. Sun International Average Room Rate vs. CPIX Figure 65. City Lodge Average Room Rate vs. CPIX 20.0% 16.0% 15.0% 10.0% 14.0% 12.0% 10.0% 8.0% 5.0% 6.0% 0.0% 4.0% 2.0% -5.0% 0.0% FY03a FY04a FY05a FY06a FY07a FY08e FY09e FY10e FY99a FY00a FY01a FY02a FY03a FY04a FY05a FY06a FY07a FY08e FY09e FY10e CPIX ARR CPIX CLH Price increase Source: Citi Investment Research and company reports Source: Citi Investment Research and company reports 2. Occupancies We forecast occupancies on an individual hotel basis. Sun International owns a number of hotels in South Africa; as a result we calculate an average occupancy rate for the group. Generally, occupancy rate is a function of branding, supply and demand. Figure 66. Sun International Occupancy rates (FY02a FY10e) Figure 67. South African Hospitality Industry Occupancy Rates (Sep 04 Mar 08) 90% 80% 70% 60% % 40% 30% Percentage (%) % 10 10% 0 0% FY02a FY03a FY04a FY05a FY06a FY07a FY08e FY09e FY10e Sep-04 Nov-04 Jan-05 Mar-05 May-05 Jul-05 Sep-05 Nov-05 Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 Occupancy rate Industry Occupancy Source: Citi Investment Research and company reports Source: Citi Investment Research and Inet 44

45 3. Room Supply Some of the core hotel operators in South Africa include, amongst others, City Lodge, Southern Sun, and Protea Hotels. Sun International s focus is largely on resorts, though. Nevertheless, leading to the 2010 Soccer World Cup we are likely to see a mismatch between supply and demand in hotel rooms. We would expect demand to exceed supply leading up to this big event. As a result, this creates an opportunity for most of the international hotel groups to scale up in South Africa. Already, most operators have announced their plans to increase their number of hotel rooms in South Africa. Among others: 1. Protea Hotels indicated that its target is to build 28 to 30 hotels in the next three years. Currently, it has 86 hotels in South Africa and 26 elsewhere in Africa. Our view is that its target is rather more aggressive than that of City Lodge. 2. Holiday Inn Express has also indicated that it is building 10 hotels in the next few years. 3. Rezidor Hotel Group (the world s largest and fastest-growing hotel company, which also operates the Radisson) has indicated its aggressive expansion plans for Africa, which will see it open several hotels in the next few years, three of them in South Africa. 4. Southern Sun has also indicated its intentions to take advantage of this opportunity to scale up and built more hotels in South Africa. Despite the projected increase in supply, we would expect the demand to continue exceeding supply given the intact fundamentals in the sector. 4. Food & Beverage and other Food & Beverage and other contribute around 12% to group revenues. 45

46 Cost Drivers 1. Employee costs As with hotel operators, casinos are also classified as labour-intensive. Employee costs make up a large portion of the total operating costs, the same applies to Sun International s peers. We anticipate employee costs to grow in line with inflation in South Africa. Figure 68. Employee Costs Forecasts (FY05a FY10e), Rand Millions FY05A FY06A FY07A FY08E FY09E FY10E Number of employees 7, , , , , ,414.0 Average number of employees 7, , , , , ,414.0 Salary costs per employee 139, , , , , ,838 %growth in employee costs 3.7% 7.4% 3.2% 10.0% 9.0% 8.0% CPIX 4.2% 4.9% 5.8% 6.2% 5.7% 5.5% Revenue per employee , ,182.8 % Change in revenue per employee 20.0% 12.8% 11.8% 9.4% 16.1% 13.1% Employee costs as a % of revenue 21.4% 20.4% 18.8% 18.9% 17.8% 17.0% Source: Citi Investment Research and company reports 2. Levies and VAT on casino revenues Figure 69. Provincial Tax rate Rates of tax Gauteng 9.0% North-West 3.0% Northern Cape 8.0% Mpumalanga 5.7% Limpopo 6.0% Free State 7.0% Source: Gauteng Gambling Board All gaming machine operators are liable for certain levies and duties on income generated by their gaming machines. Rates of taxes on casino revenues differ considerably, primarily because different casinos are regulated by their respective provincial gaming boards. The figure alongside shows the different tax rates for certain provinces in South Africa. We highlight that for provinces not mentioned on the figure alongside; the tax rate is based on taxable income recorded, and ranges from as low as 3% and going as high as 17%. We have also done a survey, looking at gaming taxes & commissions as a percentage of revenue for different players and note that the ratio is similar amongst Sun International s listed peers. Figure 70. Gaming Taxes & Levies (FY07a) Sun International Gold Reef Peermont Gaming taxes & commissions 1, Gaming taxes & commissions % of casino revenue 21.1% 19.6% 19.7% Source: Citi Investment Research and company reports Our assumptions for tax levies assume that there won t be any material changes to tax rates across the board. We forecast gaming taxes & commissions to be around 20% of the casino revenues. The table on provincial tax rates table has been included in Appendix B. 46

47 Figure 71. Casino Tax and Levies (FY05a FY10e) [Rand Millions] FY05A FY06A FY07A FY08E FY09E FY10E Casino Revenues 3, , , , , ,651.4 Levies and VAT on casino , , , ,607.2 revenues Levies and VAT as a % of casino revenues 21.1% 20.9% 21.1% 21.0% 21.0% 21.0% Source: Citi Investment Research and company reports 3. Promotional and marketing costs Sun International spends around 8.3% of its revenue in promotion and marketing; this gives the group a benefit in terms of development and greater product breadth and marketing, and also helps in branding the business. Generally, a strong and well-recognised brand reduces the perceived risk on the side of the patrons. Successful branding attracts new players (thereby increasing customer volumes) to a gaming facility and retains existing ones. Considering the current level of competition in the sector as well as the expected increased competition, we would expect marketing costs to increase as the battle to win market share in the market (particularly Gauteng province) intensifies. The ratio of 8.3% is still relatively low as companies in the United States of America spend circa 20% of revenues in comps, thus highlighting the importance of comps in generating additional casino revenue. Figure 72. Promotional and Marketing costs (FY05a FY10e) [Rand Million] FY05A FY06A FY07A FY08E FY09E FY10E Total Revenue 5, , , , , ,952.3 Promotional and marketing costs Growth in promotional and 60% 13% 13% 12% 16% 13% marketing costs Promotional and marketing costs as a % of revenue 8.7% 8.5% 8.3% 8.5% 8.5% 8.5% Source: Citi Investment Research and company reports 47

48 SWOT Analysis Figure 73. Sun International SWOT Analysis Strengths Weaknesses A Dominant Player locally, with over 40% market share in South Africa Limited growth in South Africa Experience and platform to venture into new markets given its size Stringent regulations create high barriers to entry Strong brand recognised Internationally Opportunities Threats Scale to expand further in other African and overseas markets if opportunities arises Strong Customer Loyalty Regulations Household Disposable Income under pressure due to higher interest rates and inflation Eastern Cape Licences expire every ten years Source: Citi Investment Research analysis 48

49 Earnings Prospects Income Statement Figure 74. EPS and DPS (FY04 FY10e) Cents per share 1, , FY04A 33% EPS CAGR FY05A FY06A EPS Source: Citi Investment Research and Co reports Figure 75. Sun International Quarterly EBITDA Margin 40.0% 30.0% 20.0% 10.0% 0.0% 34.3% 35.0% 37.5% 38.0% 37.6% FY07A 37.3% DPS FY08E 38.0% 30.4% FY09E 36.9% Q1 Q2 Q3 Q4 FY Source: Citi Investment Research and Co reports FY10E 35.2% Our earnings estimates for FY08e FY10e are R6.72, R8.40, R10.70, respectively. Our FY07 estimate of R6.72 (down 6% on the prior year) is slightly below consensus estimates of R6.77. Earnings are negatively affected by higher interest charges due to higher gearing. Our estimates assume the following: Revenue growth: We forecast revenue growth of c9.3% in FY08e, driven mainly by the hotel business as well as food and beverage. Casino revenue growth is expected to remain sluggish, given a general slowdown in household disposable income. For FY09 and FY10e, we are looking for an average revenue growth of 15%, aided by growth from the new developments (Chile and Nigeria). EBITDA: We anticipate slightly lower EBITDA margins of 35% in FY08, versus 36.9% in FY07. However, we still expect margins to come under severe pressure in the last quarter of FY08 (see chart alongside). Interest charges: 1H08 saw R289m financing costs arising from the Group s new capital structure. Additional funding arose due to the acquisition of 61.3% of Real Africa Holdings in September 2006, and the share buyback on the 30 th July 2007 for R2.3bn. Also, preference share dividends is included as part of total interest bill. We forecast total financing costs of R654m for FY08e. We calculate an interest coverage ratio above 3x for Sun International. This means that Sun International should be able to meet its interest expenses requirements, and as a result we are not concerned at all. Tax rate: In 1H08 tax rate was 61%. The overall effective tax rate was much higher due to 1) the non-deductibility of the BEE charge and 2) as a consequence of additional preference share funding. Projected FY08e tax rate is 35%, higher than the standard corporate tax rate of 28% in South Africa. 49

50 Balance Sheet and Cash Flow Figure 76. Capital Commitments, FY08e US$ R'm GrandWest expansion the Golden Valley Lodge 65.0 Sun City Multi-Parkade level at Carnival City Carousel Other 31.0 Casino project in Chile $200m 1,406.0 Nigerian project $120m Major upgrades and refurbishments of properties Sun City Lesotho 58.0 Swaziland 24.0 Other 39.0 Capex: Figure 76 alongside shows capex commitments for FY08e, which totaled R3.6bn. Majority of capex, is mainly driven by new developments (Chile and Nigeria). In South Africa, most of the capital expenditure is emanating from refurbishments and expansion. Working capital: The increase in FY07 was driven by R181m of accounts payable and accruals. Stock levels (although immaterial) have been relatively stable. Going forward, we expect stock levels to increase gradually. Debt: Sun International s debt has increased substantially in FY07, reaching R3.5bn. Debt was raised to fund the share buyback as well as the acquisition of a stake in Real Africa Holdings. We estimate Debt/Ebitda to be around 1.4x. We are not concerned about the current gearing ratios as the business is highly cash flow generative. Ongoing asset replacement and minor refurbishment Casino equipment replacement IT equipment Other Source: Citi Investment Researc 50

51 Figure 77. Sun International Summary of Financial Statements (2005a 2012e) priced as at 15 August 2008 Sun Int (SUIJ.J) 2005A 2006A 2007A 2008E 2009E 2010E 2011E 2012E Kgosiet sile S Rahube Price (R) Valuation Ratios Price date 15-Aug-2008 P/E (x) kgosietsile.rahube@citi.com 52-week range (R) EV/EBITDA (x) Shares out st anding (M )* EV/ Sales (x) Investment Rat ing 1 Free float (%) 100 P/CF (x) Risk Rating M Avg daily volume 12 mths (K) 174 P/BV (x) Target price (R) Exchange JNB Dividend yield (%) Dividend - next 12 mths (ZAR) 3.73 Market cap (RM) 9,811 Per Share Data (R) Expected price return (%) 12.9 Enterprise value (RM ) 13,936 EPS (adjusted) , , ,645.1 Expected dividend yield (%) 4.0 Fiscal year end 30-Jun EPS (reported) , , ,645.1 Expected total return (%) 16.9 Model updated 13-Aug-2008 BVPS 2, , , , , , ,949.1 CFPS 1, , , , , , , ,302.8 Price Performance Cash EPS 1, , , , , , , ,384.3 DPS Profit & Loss (RM ) Net sales 5,140 5,949 6,937 7,619 8,846 10,002 10,843 12, Operating expenses (3,776) (4,499) (5,000) (5,571) (6,535) (7,291) (7,791) (8,700) EBIT 1,363 1,450 1,937 2,048 2,312 2,712 3,052 3, Net interest expense (179) (176) (236) (577) (538) (449) (385) (316) 40 Non-operating/except ionals (10) Pre-tax profit 1,220 1,326 1,691 1,471 1,774 2,262 2,666 3, Tax (384) (517) (669) (520) (568) (724) (853) (1,016) 13-Sep-07 6-Dec Feb May Aug-08 Ext raordinary items SUIJ.J.JALSH Minority interest/pref. dividends (220) (261) (224) (280) (367) (469) (493) (518) Reported net income ,069 1,320 1,642 Adjusted earnings ,069 1,320 1,642 Valuation Growth Rates (%) EPS (adjusted) growth (6.5) Net income growth (14.6) (15.9) EBIT growth Sales growth Dividend growth (6.6) Cash Flow (RM ) Operating cash flow 1,378 1,437 1,904 2,170 2,560 2,819 2,994 3,297 2 Depreciation/amortization Net working capital 113 (7) Investing cash flow (1,014) (336) (1,517) (1,132) (1,933) (947) (435) (501) 2005A 2006A 2007A 2008E 2009E 2010E 2011E 2012E Capital expenditure (982) (568) (972) (1,209) (1,979) (1,023) (575) (711) EV/ EBITDA ( x) P/ E ( x) Acquisitions/disposals (258) 6 (909) Financing cash flow (265) (952) (48) (1,146) (1,143) (1,177) (1,277) (1,406) Profitability Trend Borrowings , ,800 3,000 Dividends paid (380) (498) (581) (492) (560) (652) (752) (881) 1,600 Change in cash (108) (517) 695 1,281 1,390 2,500 Balance Sheet (RM ) 1,400 1,200 2,000 Total assets 7,558 7,541 8,134 8,645 9,439 10,465 11,626 13,067 1,000 Cash & cash equivalent , ,159 2,440 3,830 1,500 Net fixed assets 5,265 5,407 5,883 6,506 7,785 8,081 7,941 7, ,000 Total liabilities 3,713 3,715 5,144 7,496 7,644 7,782 7,883 8, Debt 2,330 2,326 3,546 5,846 5,846 5,846 5,846 5, Shareholders' funds 3,845 3,825 2,990 1,149 1,795 2,682 3,743 5,022 Shareholders' equit y 3,152 3,084 2, ,153 2,040 3,101 4, A 2006A 2007A 2008E 2009E 2010E 2011E 2012E Profitability/ Solvency Ratios Net Income (US$M) FCF (US$M) EBITDA margin (%) Net margin (%) ROE adjusted (%," status=" &$A$ Solvency ROIC (%) Debt to capital (%) Net debt to equity (%) Debt to EV (%) Interest coverage (x) na Current ratio (x) A 2006A 2007A 2008E 2009E 2010E 2011E 2012E Net debt t o equity (%) FCF/ Net int erest (x) *Shares out standing associat ed wit h t he quot ed securit y. Source: Powered by datacentral 51

52 Sun International Company Description Sun International Ltd is an investment holding company for a group of companies that operate in the entertainment and leisure industries. The Group owns and operates casinos resorts, hotels, and casinos, and has other operations. Sun International operates in Africa and Latin America. Investment Thesis We have initiated coverage on Sun International with a Buy/Medium Risk recommendation and a target price of R109. Sun International offers a portfolio of attractive assets (i.e. GrandWest, Sun City, Carnival City, Sibaya and Boardwalk) arguably five of the most dynamic gaming markets in South Africa and the biggest casinos by revenue in its portfolio. Sun International has the highest casino market share, c43%, in South Africa. While over the short term it is hard to be too optimistic on the outlook for gross gambling revenues in South Africa given a slowdown in consumption expenditure, Sun International is expected to generate 25% 3-year CAGR growth in earnings, driven by 1) new markets (Chile and Nigeria, which we view as positive), and 2) the hotel business, which remains buoyant in South Africa. Currently Sun International s valuation looks attractive and we see it as a good entry point to gain exposure to its strong cash flow returns and resilient hotel business. Valuation We employ both absolute and relative valuation metrics to derive an equity value for Sun International. However, an absolute metric based on a fundamental SoTP DCF analysis is our favoured approach as it captures the value of all the casinos wholly and partially owned by Sun International. Using this method, we derive a value of R109 per share, which we set to equal our target price. For our free cash flow assumptions, we use the following: riskfree rate as per the R157 (10 year bond yield) bond of 9.2%; beta of 1x, in line with the market; estimated equity risk premium of 5%; a WACC of 11.2% is estimated; and long-term growth of 6%. We also cross check our fundamental analysis with PE relative valuation multiple (R100) and the Dividend Discount Model (R120). Risks We rate Sun International Medium Risk. The risk rating on the stock is derived after consideration of a number of a number of factors. These factors include an assessment of industry-specific risks, financial risk and management risk. In addition, we consider share price volatility, based upon the input of the Citi quantitative research team, as a possible indicator of future stock-specific risk. With regard to Sun International, we would highlight the main risks to the achievement of our target price as: 52

53 Economy: The casino industry, similar to many other industries greatly depends on the conditions of the economy. Economic instability yields a scarcity of consumer spending, and in times of economic stability, local government is less likely to legalise casinos or provide more licenses (mainly because government is no longer in need of casino taxes to boost their revenues during these times). Regulations: Regulations (which are often slow in coming) are typically outside the control of management and can have a significant impact on the profitability of a company, both negative and positive. Asset Concentration: Sun International generates c65% of operating profits from four casinos out of thirteen. This degree of concentration could cause earnings volatility. Although we foresee prospects in the gaming industry in South Africa, we highlight that a more diversified asset base would provide superior predictability of earnings. Competitive environment: Gauteng province (which accounts for over 40% of the gaming market share in South Africa), is exposed to competitive threats from the new properties opening in the province. The industry is likely also to be characterised by cannibalisation. 53

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55 Gold Reef Resorts Ltd 55

56 Gold Reef Resorts Limited The chart below gives a breakdown of revenue and cost structure at Gold Reef Resorts. Figure 78. Gold Reef Resorts Revenue Breakdown, FY07a Figure 79. Gold Reef Resorts Casino Revenue Breakdown, FY08e Net gaming 92% Theme Park 4% Hotel 1% Theatre 0% Food & Bev 2% Other 1% Gold Reef 48% Golden Horse Casino 10% Mykonos Casino 5% Garden Route Casino 8% Goldfields Casino* 5% Gold Reef Management 3% Silverstar* 21% Source: Citi Investment Research and Company reports Source: Citi Investment Research Investment Case Fundamentals softening; while the stock is discounting the down-cycle, it is not enough in our view. Gold Reef generates c92% of its revenues from casino gambling; given a general slowdown in the gaming fundamentals in South Africa, we are of the opinion that Gold Reef is likely to be more negatively affected than Sun International. Gold Reef is expected to generate c20% CAGR growth in earnings. Currently Gold Reef trades on a trailing P/E of 11x and a forward P/E of 10.4x. New Casino Opening: Silverstar, which opened its doors on the 11 th December 2007, should add to the revenues of the group. In recent results released for the year ended December 2007, Silverstar was only included for several weeks and contributed c. 1% to revenues. EBITDAR margins of c30% were not great when compared to its peers, but our view is that margins should steadily improve to the mid-thirties medium term. It is difficult to accurately forecast initial earnings at new casinos, as well as the dilution in win per position that existing casinos will likely experience as new supply is absorbed. We have therefore annualised the revenues and estimate that Silver Star is likely to post revenues of around R500m (or c20% contribution to group revenues) in FY08e. Currently, Silver has 8-9% market share, with the target being 10%. Currently, Silver-star has 8-9% market share, the target is 10% This is directionally consistent with our sector-wide views of margin erosion. Inevitably there are margin pressures at new casinos on the heels of a higher cost structure and dwindling industry gaming revenue growth: Essentially, it can be argued that the timing of the SilverStar casino opening was not particularly ideal in the current economic environment, given tough trading conditions. Management highlighted that the focus would be on managing revenue growth in the near term, while margins are being squeezed due to the high cost structure. We expect group margins to remain under pressure, driven by the higher fixed cost component and slowing revenue growth. If we were able to get a sense of what revenue growth is required to thwart the margin squeeze, driven by the high cost structure, we could have been more constructive on the stock. 56

57 New direction for growth needed: Gold Reef is heavily exposed to the casino revenues. As highlighted earlier, 92% of its revenues are generated from casino gambling and only 1% from hotel operations. Further, Gold Reef generates c60% of its overall revenues from one casino (Gold Reef City). In our opinion, this creates risks of asset concentration. Gold Reef City operates in the Gauteng province (although the most lucrative market in South Africa, it is also exposed to a high degree of competition for patrons). The industry grew quickly as a result of new licenses being issued Figure 80. Gold Reef FCF vs. FCF Yield (FY04a FY10e) With revenue growth slowing down and competition heating up (particularly in Gauteng), Gold Reef is likely to find itself under pressure. Operating leverage The higher the degree of operating leverage; the greater the potential danger from forecasting risk. That is, if a relatively small error is made in forecasting sales, it can be magnified into large errors in cash flow projections. Given Gold Reef s stable operating leverage, we would expect significant margin squeeze but less so when compared with Sun International FY04A FY05A FY06A FY07A FY08E FY09E FY10E 20.0% 15.0% 10.0% 5.0% 0.0% -5.0% Cash Flow Analysis Over the years, Gold Reef generated a three-year average free cash flow until FY06 of R159m. Cash flow was negative in FY07, mainly driven by the opening of Silverstar casino. We forecast free cash flow to be positive in FY08e, implying a cash flow yield of just below 10% % % % % FCF FCF Yield Source: Citi Investment Research and Co reports Catalyst Despite there being no short-term catalyst for the casino industry, we highlight that Gold Reef generates c92% of its revenues from casino gambling. We therefore deduce that it is likely to be more affected by the general slowdown in gambling revenue growth, as well as the inevitable operating margin squeeze. In absence of any obvious positive catalysts, we initiate coverage on Gold Reef Resorts with a Hold/Medium Risk (2M) recommendation and a target price of Corporate activity Gold Reef Resorts was on the verge of being taken out by consortium known as Bidco (including South African private equity firm Ethos and Goldman Sachs. The transaction valued Gold Reef at R34 per share; however, the deal did not materialise after Gold Reef failed to get the right approval from the various gambling boards. Earnings outlook Our earnings estimates for FY08e FY10e are R1.28, R1.60, and R2.12, respectively. Our FY07 estimate of R1.276 (down 15% on the prior year) is below the consensus estimates of R1.45. Earnings are negatively affected by higher interest charges due to higher gearing and the difficult trading conditions, particularly in Gauteng province, where competition is intensifying. Valuation: Our valuation is based on a sum-of-the-parts analysis, after discounting all the cash flows for all the casinos (using discounted cash flow). Our view is that this methodology is sufficient in order to capture the value of all the casinos wholly and partially owned by Gold Reef. We therefore derive a fair value of R17.00, which we set as our target price. The main assumptions in our casino DCF valuation are beta of 1x, risk free rate of 9.4% and an equity risk premium of 5%. We initiate coverage with a Hold/Medium Risk (2M) recommendation. 57

58 Valuation and Risks Valuation Methodology We employ both absolute and relative valuation metrics to derive an equity value for Gold Reef Resorts. However, an absolute metric based on a fundamental SoTP DCF analysis is our favored approach, as it captures the value of all the casinos wholly and partially owned by Gold Reef Resorts. We also cross check our fundamental analysis with a PE relative valuation multiple, and lastly we apply the Dividend Discount Model. Valuation Gold Reef Resorts offers a reasonable level of breakdown of divisional profitability in its financial statements. We have therefore modelled the company on a casino-by-casino basis, as opposed to the typical valuation methodology, which looks at the group from the basis of group revenues downwards. Our valuation is based on a sum-of-the-parts approach, after discounting all the cash flows for all the casinos. Our view is that this methodology is sufficient in order to capture the value of all the casinos wholly and partially owned by Gold Reef. Our sum-of-parts is presented below. Figure 81. Gold Reef Sum-of-the parts Valuation Analysis (Based on DCF) [Rand millions] Implied EBITDA multiple based on EV Net (Debt)/cash as at Dec 2007 EBITDA 2008 Enterprice Value EV ex Debt Economic Interest % of Value Gold Reef City ,556.4 (275.0) 2, % 2,281 56% Golden Horse Casino (33.0) % % Mykonos Casino % 267 7% Garden Route Casino (22.7) % % Goldfields Casino (66.8) % 277 7% Silverstar (946.7) % 20 0% Total Value , , % Total sum of the parts value 4,092 Shares in Issue Value per share Current share price Upside 14% Source: Citi Investment Research and Company reports Figure 82. Gold Reef - WACC Assumptions WACC Calculation Cost of debt 9.4% Cost of equity 15.1% Debt ratio 58.9% Equity ratio 41.1% 11.7% Source: Citi Investment Research The methodology used in our sum of the parts valuation analysis is explained below: Enterprise value: This is calculated using a DCF-based approach. Discount rate of 11.7%: We use a discount rate of 11.7%. This is equal to Gold Reef s estimated Weighted Average Cost of Capital. Long-term growth: We applied a long-term growth of 4%, in line with economic growth. 58

59 Implied Valuation multiple of 6.9x: We note that our valuation analysis implies EBITDA multiple based on EV of 6.9x. Although this is at a significant discount to its peers globally, we highlight that it is at a premium to our top pick (Sun International). P/E Relative Valuation We analyse the P/E of Gold Reef Resorts relative to the JSE All-Share Index: The JSE/FTSE All Share Index. Gold Reef is currently trading at a historical PER of c. 1.4x to the market. However, we use an historic average PER of 1.1x for the valuation purpose. The PER is calculated from Applying a 1.1x PER to the All-share index exit PE of around 12.5x and 12- month rolling EPS of 153cps, we arrive at a value of R Figure 83. Gold Reef Relative Valuation GDF Relative valuation Exit PE GDF PER EPS Value/share Alsi R20.2 Source: Citi Investment Research Below we look at Gold Reef s historical P/E since the take-out news emerged. Figure 84. Gold Reef PE (Jan 2004 Current) Bid Lapsed Cautionary Annoucement Firm Intention of Buyout Offer Take-out talks terminated GDF in takeout discussion with Tsogo Sun 0 4-Jan-04 4-Jul-04 4-Jan-05 4-Jul-05 4-Jan-06 4-Jul-06 4-Jan-07 4-Jul-07 4-Jan-08 4-Jul-08 Source: Citi Investment Research and I-Net 59

60 Dividend Discount Model In Figure 85 below, we highlight our DDM methodology. We utilise a discount rate that is equal to our weighted average cost of capital (WACC) and a longterm growth of 4%. Figure 85. Gold Reef Dividend Discount Model DIVIDEND DISCOUNT MODEL FY07 FY08e FY09e FY10e FY11e FY12e FY13e FY14e Dividend R Dividend growth -14.7% 25.4% 32.9% 16.9% 17.1% 16.8% 12.6% Period Long term Discounted cash flow WACC 11.7% Long term growth 4.0% Valuation R16.4 Source: Citi Investment Research Risks We rate Gold Reef Resorts Medium Risk. The risk rating on the stock is derived after consideration of a number of factors. These factors include an assessment of industry-specific risks, financial risk and management risk. In addition, we consider share price volatility, based upon the input of the Citi quantitative research team, as a possible indicator of future stock-specific risk. With regard to Gold Reef, we would highlight the main risks to the achievement of our target price as: Economy: The casino industry, similar to many other industries greatly depends on the conditions of the economy. Economic instability yields a scarcity of consumer spending while in times of economic stability, local government is less likely to legalise casinos or provide more licenses (mainly because government is no longer in need of taxes to boost their revenues. Regulations: Regulations (which are often slow in coming) are typically outside the control of management and can have a significant impact on the profitability of a company, both negative and positive. Asset Concentration: Gold Reef generates c50% of revenues from one casino (Gold Reef Casino) located in the Gauteng province. This degree of concentration could cause earnings volatility. Although we, in the long run, foresee favourable prospects for the gaming industry in South Africa, we highlight that a more diversified asset base would provide superior predictability of earnings. Cannibalisation: The opening of Silverstar casino is likely to result in cannibalization in the Gauteng province. Our view is that Gold Reef city casino is likely to be more affected, given its close proximity to Silverstar, thereby resulting in own cannibalization. Expansion risks: We highlight that all of Gold Reef s operations are based in South Africa, in our opinio, management lacks the experience of operating in other markets (i.e. Africa and International). 60

61 Historical Share Price Performance Figure 86 below reflects Gold Reef Resort s historical share price movement. Figure 86. Gold Reef Historical Share Price Performance ( ) 4000 Ethos Takeoover Bid lapses Silverstar Casino opens, Dec Firm intention by Ethos to make an offer to GDF Golden Horse Casino opens, Sep 2001 Restructure and Cautionary Annoucement Tsogo Sun ends takeout offer talks 1H08 Trading update Garden Route Casino opens, Dec Dec-00 1-Sep-01 1-Jun-02 1-Mar-03 1-Dec-03 1-Sep-04 1-Jun-05 1-Mar-06 1-Dec-06 1-Sep-07 1-Jun-08 GDF [LHS] GDF/J203 [RHS] Source: Citi Investment Research and I-net Company Profile and Strategy Company Profile Gold Reef listed on the JSE in October 1999 Gold Reef Resorts Limited is a gaming and entertainment company. Its interests include Akani Egoli (Pty) Limited, which operates Gold Reef City Casino and Theme Park West Coast Leisure (Pty) Limited, which operates Mykonos Casino Akani Msunduzi (Pty) Limited, which operates Golden Horse Casino Garden Route Casino (Pty) Ltd, which operates the Garden Route Casino Goldfields Casino and Entertainment Centre (Pty) Ltd, which operates Goldfields Casino Silverstar Development Ltd Queens Casino 61

62 Strategy Although it is the company s strategy to seek growth opportunities across Africa and other markets, management indicated that it is difficult to find the right acquisitions outside of South Africa. For now, the strategy is largely focused in South Africa, however, if any opportunities arise elsewhere, those will be duly considered. New Developments in South Africa Silver Star Casino Silver Star casino was opened in December 2007 and managed to acquire between 8% and 9% market share in the Gauteng Province. Management indicated Silver Star is still finding its feet on the heels of slowing revenue growth and higher cost structure. The casino features 756 slots and 26 tables. Capital expenditure amounted to R759m in FY07a. In total, total capex is likely to remain around R1.1bn. Overall, our view is in a long run, Silverstar casino should be viewed as positive for the following reasons: 1. It is an opportunity to grow revenue and EBITDA, significantly. 2. It enables Gold Reef Resorts to diversify earnings and reduce reliance on Gold Reef City. 3. The property introduced productive gearing. Queens Casino Queens casino opened in December 2007, and management highlighted that the casino has not been performing well. Queens Casino is fairly small and it features 180 slots and 6 tables. Capital expenditure for FY07 was only R92.5m. Gold Reef has a 25.1% stake in the casino. Total capex is likely to remain around R125m. Vaal River casino Gold Reef holds a controlling stake in Vaal River Casino, circa 50%. Vaal river casino has applied for a license in the Sasolburg area. Though they are the only applicant for the license, Emerald Casino 29 has objected to the casino application. Management appears optimistic that the deal will go through. We have not included this in our numbers yet, until further clarification. 29 Operated by London Clubs International 62

63 Gold Reef Group Structure Figure 87. Gold Reef Group Structure Source: Company Reports 63

64 Key Drivers Gold Reef revenues are largely generated from its gaming division (c92% contribution). Hotel revenue contribution is only 1%, below the contribution from food and beverage of around 2%. The theme park contributes 4% to the overall revenues for Gold Reef. We therefore highlight that Gold Reef Resort is more geared to the casino operations, with one casino (Gold Reef City) contributing 63% to group revenues. Figure 88. Revenue Contribution by Category, FY07a Figure 89. Operating expense contribution by Category, FY07a FY07 FY07 Theme park 4% Hotel 1% Theatre 0% Gaming levies and VAT 26% Net gaming win 92% Other 0% Food & bev 2% Parking 0% Mgmt fees and commisions 0% Rental inc 1% Other 47% Mgmt fees and commisions 0% Parking 0% Food and bev 3% Theatre 1% Gaming expenses 17% Theme Park 5% Hotel 1% Source: Citi Investment Research and Company reports Source: Citi Investment Research and Company reports Revenue Forecasts We forecast overall revenue growth of 32.7% to R2.3bn, driven predominantly by the inclusion of Silverstar casino for the first time in this financial year. We anticipate that Silverstar should add around cr500m to revenues. If we strip out the new casino, our revenue forecast drops to around 5%. For FY09e and FY10e, we forecast average revenue growth of 7.8%. For Gold Reef City casino, which accounts for circa 50% of revenues, we forecast sluggish revenue growth of 3.4%. Our view is that the opening of Silverstar casino should result in Gold Reef s own cannibalisation (as discussed earlier in our report) due to close proximity. Figure 90. Gold Reef - Divisional Forecasts (FY06a FY10e) [Rand Millions] Revenue FY06A FY07A FY08E FY09E FY10E Gold Reef City , , , ,318.7 Casino , , , , Theme Park Golden Horse Casino Mykonos Casino Garden Route Casino Goldfields Casino* Silverstar* Queens Casino Gold Reef Management Gold Reef - - Consolidation (68.5) (71.6) (71.55) (71.55) (71.55) Total 1, , , , ,687.0 Source: Citi Investment Research and Company reports 64

65 Cost Drivers Employee Costs We expect the average employee costs to increase in line with inflation. Although it appears that salary costs per employee actually showed a decline in FY07, this could have been due Silver-star casino opening in December (the last month of the financial year). Figure 91. Employee Costs (FY05a FY10e) [Rand Millions] FY05A FY06A FY07A FY08E FY09E FY10E Number of employees 2,089 2,411 3,175 3,175 3,175 3,175 Salary costs per employee 121, , , , , ,152 %growth in employee costs n/a 7.6% -12.5% 11.0% 9.0% 8.0% CPIX 4.2% 4.9% 5.8% 6.2% 5.7% 5.5% Revenue per employee % Change in revenue per employee n/a 12.8% -12.8% 32.7% 6.4% 9.3% Employee costs as a % of revenue 22% 21% 20.8% 17% 18% 18% Source: Citi Investment Research and Co reports Gaming Levies and VAT Figure 92. Provincial Tax rate Rates of tax Gauteng 9.0% North-West 3.0% Northern Cape 8.0% Mpumalanga 5.7% Limpopo 6.0% Free State 7.0% Source: Gauteng Gambling Board All gaming machine operators are liable for certain levies and duties on income generated by their gaming machines. Rates of taxes on casino revenues differ considerably, primarily because different casinos are regulated by their respective provincial gaming boards. Figure alongside shows how different the tax rates are for certain provinces. We highlight that for provinces not mentioned on the figure alongside; the tax rate is based on taxable income recorded, and ranges from as low as 3% to as high as 17%. We have also done a survey, looking at gaming taxes & commissions as a percentage of revenue for different players and note that the ratio is similar amongst Gold Reef s listed peers. Figure 93. Gaming Taxes & Levies (FY07a) [Rand Millions] Sun International Gold Reef Peermont Gaming taxes & commissions 1, Gaming taxes & commissions % of casino revenue 21.1% 19.6% 19.7% Source: Citi Investment Research and company reports Our assumptions for tax levies assume that there won t be any material changes to tax rates across the board. We therefore forecast gaming taxes & commissions to be around 20% of the casino revenues. The table on provincial tax rates table has been included in Appendix B. Figure 94. Gold Reef - Levies and VAT on casino revenues [Rand Millions] FY05A FY06A FY07A FY08E FY09E FY10E Casino Revenues 1, , , , , ,469.9 Levies and VAT on casino revenues (207.6) (271.3) (310.2) (417.6) (443.2) (484.1) Levies and VAT as a % of casino revenues 19.8% 19.6% 19.6% 19.6% 19.6% 19.6% Source: Citi Investment Research and Company Reports 65

66 Promotional and marketing costs Gold Reef spends just about 7.3% of its revenues in promotional and marketing costs (below Sun International s 8.3%). As indicated previously, spending on promotion and marketing costs should be an overall plus in terms of development and greater product breadth and marketing, it also helps in branding a business. Generally, a strong and well-recognised brand reduces the perceived risk on the side of the patrons. Successful branding attracts new players (thereby increasing customer volumes) to a gaming facility and retains existing ones, further. Considering the level of competition in the sector and the continued increasing competition, we would expect marketing costs to increase as the battle to win market share in the market (particularly Gauteng province) intensifies. Figure 95. Gold Reef - Promotion and marketing costs [Rand Millions] FY05A FY06A FY07A FY08E FY09E FY10E Total Revenue 1, , , , , ,687.0 Promotional and marketing costs (107.5) (113.7) (126.3) (184.9) (196.7) (215.0) Growth in promotional and marketing 27.2% 5.8% 11.1% 46.4% 6.4% 9.3% costs Promotional and marketing costs as a % 9.2% 7.5% 7.3% 8.0% 8.0% 8.0% of revenue Source: Citi Investment Research and Co reports SWOT Analysis Figure 96. Gold Reef Resorts SWOT Analysis Strengths Weaknesses Good margins and cash flow High barriers to entry created by stringent regulations Dependence on gambling revenues (92% of total revenues) Asset concentration, GDF generates over 60% of its revenues from one casino (Gold Reef casino) Opportunities Threats New casino in Gauteng to result in market share gains Expand in the hotel space Private equity takeout? Cannibalisation in the Gauteng province Regulations Sluggish industry revenue growth could result in margin compression amid higher cost structure Source: Citi Investment Research analysis 66

67 Figure 97. Gold Reef EPS and DPS (FY04 FY10e) Cents per share FY04A 17% EPS CAGR FY05A EPS FY06A Source: Citi Investment Research and Co reports FY07A DPS FY08E FY09E FY10E Earnings Prospects Income Statement Our earnings estimates for FY08e FY10e are R1.28, R1.60, and R2.12, respectively. Our FY07 estimate of R1.276 (down 15% on the prior year) is below the consensus estimates of R1.45. Earnings are negatively affected by higher interest charges due to higher gearing and the difficult trading conditions, particularly in Gauteng province, where competition is intensifying. Our estimates assume the following: Revenue growth: As indicated earlier, we forecast overall revenue growth of 32.7% to R2.3bn, driven predominantly by the inclusion of Silverstar casino for the first time in this financial year. We anticipate that Silverstar should add around cr500m to revenues. If we strip out the new casino, our revenue forecast drops to around 5%. EBITDA: We forecast EBITDAR margin of 36% in FY08e, versus 43.6% in FY07a. Margins are generally under pressure primarily due to a slowdown in revenue growth. Gold Reef s new casino (Silverstar) is also not achieving extraordinary margins when compared to its peers in Gauteng. Interest charges: Additional funding was raised for the development of the new casinos or developments. However, interest expense was capitalised in the past until the opening of the respective casino or development. We now anticipate interest charges to be reflected in the income statement. We forecast interest costs of R188m in FY08e. Tax: FY07a tax rate was 50% (above the corporate tax rate of 28% in South Africa). The main reason for a higher tax rate was the non-deductibility of certain expenditures (estimated at 16%). We project a tax rate of 32% in FY08e. Figure 98. Gold Reef Turnover (Rand billion) Figure 99. Gold Reef EBITDAR (Rand billion) 3, , , , , , , FY05A FY06A FY07A FY08E FY09E FY10E - FY06A FY07A FY08E FY09E FY10E Source: Citi Investment Research and Company reports Source: Citi Investment Research and Company reports 67

68 Balance Sheet and Cash Flow Capex: Capex of over a billion rand in FY07 was predominantly driven by the opening of Silverstar casino, which accounted for the majority of the capital expenditure. For FY08e, we forecast capex of R433.6m. Capex for FY08e include the completion of Silverstar and the refurbishment at Gold Reef City. Debt: In FY07, Gold Reef raised debt from cr0.39bn to R1.3bn. As indicated above, higher debt is likely to result in higher finance charges. However, given the group s ability to generate cash flow, we are not concerned about higher gearing. 68

69 Figure 100. Gold Reef Resorts Summary of Financial Statements (2006a 2012e), Priced as at 15 Aug 2008 Gold Reef Resort (GDFJ.J) 2006A 2007A 2008E 2009E 2010E 2011E 2012E 2013E Kgosiet sile S Rahube Price (R) Valuation Ratios Price date 15-Aug-2008 P/E (x) kgosietsile.rahube@citi.com 52-week range (R) EV/EBITDA (x) Shares outstanding (M)* EV/Sales (x) Investment Rat ing 2 Free float (%) 100 P/CF (x) Risk Rating M Avg daily volume 12 mths (K) 430 P/BV (x) Target price (R) Exchange JNB Dividend yield (%) Dividend - next 12 mths (ZAR) 0.55 Market cap (RM) 4,377 Per Share Data (R) Expected price return (%) 13.4 Enterprise value (RM ) 5,122 EPS (adjusted) Expected dividend yield (%) 3.7 Fiscal year end 31-Dec EPS (reported) Expected total return (%) Model updated 5-Aug-2008 BVPS , , , , ,604.1 CFPS Price Performance Cash EPS DPS Profit & Loss (RM ) Net sales 1,517 1,742 2,311 2,459 2,687 2,907 3,180 3, Operating expenses (1,009) (1,337) (1,664) (1,742) (1,845) (1,982) (2,154) (2,337) EBIT ,025 1, Net interest expense (25) (18) (128) (88) (55) (18) Non-operating/except ionals (1) Pre-tax profit ,058 1,223 Tax (159) (195) (166) (202) (237) (273) (317) (366) Extraordinary items Minority interest/pref. dividends (69) (49) (48) (47) (46) (45) (44) (44) Reported net income Adjusted earnings Valuation Growth Rates (%) EPS (adjusted) growth (15.3) Net income growth 10.2 (42.7) EBIT growth 39.9 (20.3) Sales growth Dividend growth (100.0) - (14.7) Cash Flow (RM ) Operating cash flow , Depreciation/amortization Net working capital 49 (63) Investing cash flow (733) (1,241) (280) (186) (168) (167) (167) (167) A 2007A 2008E 2009E 2010E 2011E 2012E 2013E Capital expenditure (351) (1,065) (280) (186) (168) (167) (167) (167) EV/ EBITDA ( x) P/ E ( x) Acquisitions/disposals (434) (129) Financing cash flow 270 1,106 (122) (153) (204) (238) (279) (325) Profitability Trend Borrowings ,000 Dividends paid (104) (150) (122) (153) (204) (238) (279) (325) Change in cash (47) Balance Sheet (RM ) Total assets 2,210 4,210 4,475 4,764 5,134 5,554 6,039 6,594 Cash & cash equivalent ,158 1,574 2,055 2, Net fixed assets 1,278 2,280 2,438 2,499 2,540 2,579 2,615 2, Total liabilities 825 1,751 1,785 1,797 1,815 1,832 1,854 1,878 Debt 514 1,464 1,449 1,449 1,449 1,449 1,449 1, Shareholders' funds 1,385 2,459 2,691 2,968 3,320 3,722 4,185 4,716 0 Shareholders' equity 1,188 2,427 2,658 2,935 3,287 3,690 4,152 4, Profitability/ Solvency Ratios 2006A 2007A 2008E 2009E 2010E 2011E 2012E 2013E Net Income (US$M) FCF (US$M) EBITDA margin (%) Net margin (%) ROE adjusted (%," status=" &$A$ Solvency ROIC (%) Debt to capital (%) Sep-07 7-Dec Feb May-08 GDFJ.J.JALSH 2006A 2007A 2008E 2009E 2010E 2011E 2012E 2013E Net debt to equit y (%) FCF/ Net interest (x) Aug Net debt to equity (%) (0.03) (0.14) (0.25) Debt to EV (%) Interest coverage (x) na na na Current ratio (x) *Shares out standing associat ed wit h t he quot ed securit y. Source: Powered by datacentral 69

70 Gold Reef Company Description Gold Reef Resorts is an investment holding company for a group of companies that operate in the entertainment and leisure industries. The group owns and operates casinos and other operations. Gold Reef s operations are predominantly in South Africa. Investment Thesis We have initiated coverage on Gold Reef Resorts with a Hold/Medium Risk (2M) recommendation and a target price of R Gold Reef generates the majority of its revenues (92%) from gambling. Gross gaming revenues in South Africa have been dwindling largely due to a general slowdown in the consumption expenditure. We believe that operating margins are likely to remain under pressure given a generally high cost structure of the casino operation. The opening of Silverstar casino in the Gauteng province is likely to result in cannibalisation and margin dilution given its higher cost structure. Further, it can be argued that the timing of the opening was not particularly ideal in the current tough trading environment. In addition, we believe that there are risks of asset concentration, as Gold Reef Resorts generates c60% of its revenues from one casino (Gold Reef City). We are of the opinion that a new direction for growth is required. Valuation Gold Reef Resorts offers a reasonable level of breakdown of divisional profitability in its financial statements. We have therefore modelled the company on a casino-by-casino basis, as opposed to the typical valuation methodology which looks at the group from the basis of group revenues downwards. Our valuation is based on a sum of the parts approach, after discounting all the cash flows for all the casinos. Our view is that this methodology is sufficient in order to capture the value of all the casinos wholly and partially owned by Gold Reef. Using this method, we derive a value of R17.00 per share, which we set to equal our target price. For our free cash flow assumptions, we use the following: risk free rate as per the R157 (10-year bond yield); beta of 1x, in line with the market; estimated equity risk premium of 5%; a WACC of 12% is estimated; and a long-term growth rate just below 4%. We also cross-check our fundamental analysis with a PE relative multiple valuation (R20.2) and a Dividend Discount Model (R16.4). Risks We rate Gold Reef Resorts Medium Risk. The risk rating on the stock is derived after consideration of a number of factors. These factors include an assessment of industry-specific risks, financial risk and management risk. In addition, we consider share price volatility, based upon the input of the Citi quantitative research team, as a possible indicator of future stock-specific risk. With regard to Gold Reef, we would highlight the main risks to the share price: 70

71 Economy: The casino industry, similar to many other industries greatly depends on the conditions of the economy. Economic instability yields a scarcity of consumer spending while in times of economic stability, local government is less likely to legalise casinos or provide more licenses (mainly because government is no longer in need of taxes to boost their revenues. Regulations: Regulations (which are often slow in coming) are typically outside the control of management and can have a significant impact on the profitability of a company, both negative and positive. Asset Concentration: Gold Reef generates c50% of revenues from one casino (Gold Reef Casino) located in the Gauteng province. This degree of concentration could cause earnings volatility. Although we, in the long run, foresee prospects in the gaming industry in South Africa, we highlight that a more diversified asset base would provide superior predictability of earnings. If the impact of these risk factors is more or less negative than we currently anticipate, then the share price could deviate significantly from our target price. 71

72 Casino - South African Market Conditions An overview of the Casino Industry Pre 1996 Prior to the democratic reforms in South Africa in 1994, betting on sports events, or gambling in any other form, with the exception of the profitable horse racing industry, was illegal in the country. Gambling and especially casino gambling was allowed only in the so-called independent homeland states like Bophuthatswana etc. However, despite these restrictions, unregulated, underground gaming operations started popping up around South Africa in the early-1990s. This largely illegal gambling industry consisted of up to 150,000 illegal machines in all urban areas. Amongst others, these machines: Contributed little to the economy, capex spend was minimal and they did not contribute to BEE. Were easily accessible to all (i.e. no age restrictions). Public was not protected. Payout percentages were manipulated and winnings were often not paid. It was often associated with criminal elements ( drugs, loan sharks, money laundering, et al). There were no taxes. Given all the reasons mentioned above, and following the 1994 elections, the new government decided to take steps to regulate and control the industry to ensure high standards of probity, player protection, and an ethical and accountable industry as it is today. In pursuit of this objective, the government set up a variety of commissions tasked with informing government policy on gambling. It was proposed that government acknowledge gambling as a social reality and seek to regulate the industry and ensure that some of the profits from gambling are also used to benefit the country. An overview of the South African Casino Industry Post 1996 The gaming industry in South Africa is well established and regulated. The number of casinos are limited to 40 nationally, and broken down to limited numbers by province. The licences, subject to ongoing suitability and compliance, have an indefinite life with the exception of the Eastern Cape licences. Illegal casinos are currently being shut down by the authorities. The gaming industry is estimated to be an R15bn a year business. It includes casino operations, lottery, horse racing, LPM 30 and Bingo. Casino gambling has become a major industry in South Africa The casino industry is made of different provincial gambling boards, but one province cannot generally dictate what another province can or should do. The largest concentration of casinos is in Gauteng, with seven casinos operational. The seventh and final casino license in Gauteng was opened in December 2007 and allocated to Gold Reef Resorts. 30 Limited Payout Machine 72

73 Overall, the casinos hold a larger share of the gambling market (c70% market share) and generate cr12bn in revenue. Of the casino s revenue, more than 60% comes from slot machines, which are programmed to pay out certain amounts. Smoking Casinos The smoking laws were amended in South Africa in 2002 to limit the size of smoking facilities to 25% of the total floor space, with separate extraction systems in place, this required additional capex spend to comply and reduced casino revenues. Supply The South African Casino market is large and predominantly driven by casino gambling with a share of c75%. Sun International is the holder of the largest number of casino licenses in South Africa. It currently operates 21 casinos in Southern Africa, including 13 of 34 casinos operating in South Africa. Figure 101. Forms of Gambling in South Africa, 2007 Figure 102. Group Holding Casino Licenses, 2007 Casino Gambling 75.2% Lottery 13.8% Sun International, 37.1% Peermont Global, 20.0% Century Casinos, 5.7% Horse Racing 8.4% London Clubs, 2.9% LPM 2.2% Tsogo Sun, 14.3% Bingo 0.4% Desert Palace, 2.9% Gold Reef, 17.1% Source: Citi Investment Research and CASA Source: Citi Investment Research and CASA Demand From figure 103 and 104, we deduce that there has been strong demand for gambling in South Africa. Increased spending is a result of increased household disposable income in the past. However, with the recent increases in interest rates locally, we highlight that gambling spent could be under pressure, as we have already seen with slowing gross gambling revenue growth across South Africa. Disposable Income Key driver Gambling revenue is a function of household disposable income. As depicted on the figure below. It is imperative to monitor the household disposable income as it affects the rate of gaming revenue growth for different casinos. Although the economic outlook remains positive for the industry as a whole, higher levels of inflation and increased interest rates are impacting on consumer s disposable income and tempering consumer spending. 73

74 Generally, casinos depend on tourism and leisure travel, which are directly affected by personal income and thus the economy Other drivers of gaming revenues include amongst others, good economic growth, stability in interest rates, the rand and inflation. We discuss some of these in the following section. Figure 103. South Africa - Gambling Spend as a % of disposable income Figure 104. South Africa - Casino Spend as a % of disposable income 2.00% 1.80% 1.60% 1.40% 1.20% 1.00% 0.80% 0.60% 0.40% 0.20% 1.60% 1.40% 1.20% 1.00% 0.80% 0.60% 0.40% 0.20% 0.00% % Source: Citi Investment Research, I-net and CASA Source: Citi Investment Research, I-net and CASA Global Comparisons South Africa compares with the major developed countries in terms of gaming turnover as a percentage of GDP. This, therefore, leaves little room for further upside potential in the casino industry. We therefore argue that the South African market could be mature. Figure 105. Gaming turnover as a percentage of GDP 1.20% 1.00% 0.80% 0.60% 0.40% 0.20% 0.00% Spain South Africa Italy UK USA Greece Argentina Brazil Mexico Source: Citi Investment Research and national statistics 74

75 Gauteng province is not only the biggest province in terms of gambling revenues, but also in terms of population distribution. Western Cape is the fifth biggest province in terms of population, but is second when measured against gambling revenues; this is mainly due to urbanisation (proximity of casinos to metropolitan areas). Figure 106. Percentage distribution of South African population by province ( ) RA 2007A 2007B Population % of Adults WC NC FS Provinces EC KZN MP LP GP NW Source: Citi Investment Research and SAARF 75

76 Competition Local comparisons favour Sun International In the following section, we compare Sun International and Gold Reef casinos across South Africa with its peers. Figure 107. Peer Comparison (FY07 based) Sun International Gold Reef Tsogo Sun Peermont Number of Casinos Number of slots Number of tables Casino revenue (R million) Limited Payout Machines n/a n/a 5000 n/a Food, beverage and other revenues n/a Other n/a n/a n/a 71.9 Revenues (R million) 6,937 1, EBITDA 2, n/a EBITDA margins 35.4% 32.3% n/a 41.2% Gaming taxes & commissions (R million) n/a Gaming taxes & commissions % of 21.1% 19.6% n/a 19.7% casino revenue Employee costs (R million) n/a Employee costs % of revenue 18.8% 20.8% n/a 18.7% Promotion and marketing costs (R m) n/a Promotion and marketing costs % of 8.3% 7.3% n/a 5.7% revenue Number Hotels 81 Number of rooms 3,568 13,300 1,312 Average Occupancy 74% n/a 74% Average room rate (Rands) 792 n/a 569 RevPar (Rands) R586 n/a 422 Hotel Revenue (R million) Source: Citi Investment Research and Co reports Casino Industry Cost Structure In the following figure, we provide a breakdown of the different cost drivers for the gaming companies. It would appear that employee costs constitutes the majority of the overall costs of the casino companies, followed closely by levies and VAT on casino revenues for all the casinos discussed below. Given Tsogo Sun Gaming s limited disclosure, we believe that the cost structure is not far off from its peers. 76

77 Figure 108. Sun International Cost Structure, 2007 Figure 109. Peermont Cost Structure, 2007 Property costs 4% Property and equipment rental 1% Other operational costs 9% Employee costs 27% Other operating expenses 30% Employee costs 27% Consumables and services 14% Promotional and marketing costs 12% Depreciation and amortisation 10% Levies and VAT on casino revenues 23% Depreciation and amortisation 11% Promotional and marketing costs 9% Gaming levies and VAT 23% Source: Citi Investment Research and company reports Source: Company reports Figure 110. Peermont Cost Structure, 2007 Depreciation & Amortisation 10% Employee costs 28% Other operational costs 26% Promotions and marketing 9% Property and equipment rentals 2% VAT and gaming levies 25% Source: Company reports 77

78 Provincial Casino Market Share GGR 31 Gauteng is the largest and arguably most lucrative market in South Africa, with a lion s share of c. 40% of the overall national market share. It is closely followed by the Western Cape, with GGR share of 17%. Grand West (70% held by Sun International) is dominant in the Western Cape. In Gauteng, Tsogo Sun, Peermont, and Akani Gold attract a large numbers of visitors annually. Market share is driven primarily through acquisitions, new licences, as well as extensive marketing & promotion. Figure 111. Casino Provincial Gross Gaming Revenue Share Western Cape 18% Gauteng 41% KZN 17% Limpopo 2% Free State 3% Eastern Cape 8% North West 6% Nothern Cape 1% Mpumalanga 4% Source: Citi Investment Research and CASA Below we show 2007 GGR growth for different provinces. Figure 112. Provincial Gambling Selected Provinces (Rand Million s) Province % Change Gauteng 4, , % Western Cape 1, , % KZN 1, , % Limpopo % Mpumalanga % North West % Nothern Cape % Eastern Cape % Free State % Total 10, , % Source: Citi Investment Research and Casino Association of South Africa 31 Gross Gaming Revenue 78

79 Licences Issued in South Africa Figure 113. Casino Group Holding Licences in South Africa Sun Intl. Peermont Global Century Casinos London Clubs Tsogo Sun Gold Reef Desert Palace Eastern Cape 2 1 Free State Gauteng* KwaZulu-Natal Limpopo 1 1 Mpumalanga 1 2 North West 2 2 Northern Cape** 1 1 Western Cape TOTAL Source: Citi Investment Research and Co reports Gauteng The estimated c43% market share of the South African Casino market is testament to a combination of the size of Gauteng s population as well as high propensity to gamble. It is considered the largest regional gaming market and arguably the most lucrative market in South Africa. Gauteng has issued seven licences, which are operated by Tsogo Sun, Akani Gold, Emerald Casino, Peermont Global, Afrisun Gauteng, and Sun International. Three of these 32 are large urban-based casinos near Johannesburg. Gauteng casinos attract the largest number of visitors, around 21 million people. However, due to the close proximity of the casinos, the area experiences a high degree of competition for patrons. See figure below for vital statistics on different casinos in Gauteng. The last casino to open in Gauteng was Silverstar (which opened on the 11 th December 2007). In the medium term, there should more competition among operators, which will be seeking to strengthen their position in the Gauteng market and boost their individual market share. Figure 114. Gauteng Casino Market 2007 Gauteng City Operator Population size 10.5m Capital Investment Number of visitors No of Slots Provincial No of Market Share tables 06/07 Square Footage (000s) Montecasino Fourw ays Tsogo Sun 1, ,500,000 1, % Gold reef City Joburg Akani Egoli Pty ,650,000 1, % n/a Morula Sun Casino Mabopane Sun International , % n/a Emerald Casino Resort Vandebijlpark London Clubs International 2, ,021, % 32.0 Emperors palace Kempton Park Peermont Global ,799,230 1, % Carnival City Brakpan Afrisun Gauteng n/a 3,601,000 1, % n/a Silverstar Casino Resort West Rand Gold Reef and Akani n/a ??? Source: Citi Investment Research and CASA 32 Namely, Caesar s, Montecasino and Gold Reef City 79

80 Western Cape The Western Cape casino market is estimated to have the second-largest market share in South Africa with a market value in excess of R2bn, according to the recent statistics from the Casino Association of South Africa. Currently, five casino licenses have been issued, two of them to Sun International, two more are managed by Gold Reef, and the last one is managed by Century Casinos Africa. Of all the licenses issued in that region, the most lucrative is GrandWest Casino operated by Sun International. This casino dominates the Western Cape market, capturing around 80% of the market share. GrandWest attracts circa 6 million people per annum. It is placed second only to the V&A Waterfront, South Africa s top attraction (attracting around 22 million people), surpassing Table Mountain, Kirstenbosch, Robben Island, and the Winelands. It is important also to note that 67% of current visitors to GrandWest are attracted by the entertainment on offer over and above the casino experience; therefore the recent expansion plan should help position the complex to build on its extraordinary success as a leisure destination. Figure 115. Western Cape Casino market [Rand Million] Western Cape City Operator Capital Investment Number of visitors Slots Tables Square Footage (000s) Population size 5.3m Grand West Cape Tow n SunWest Int'l 1, ,382,000 1, n/a Caledon Casino Hotel & Spa Caledon Century Casinos Caledon Pty ,568 1, n/a Club Mykonos Langebaan West Coast Leisure Pty , Garden route Casino Mossel Bay Garden Route Casino , The Golden Valley Casino Worcester Worcester Casino Pty , n/a Source: Citi Investment Research and CASA Kwazulu-Natal Kwazulu-Natal is estimated to capture market share of 17%, in line with Western Cape. SunCoast Casino and Entertainment World (operated by Tsogo Sun gaming) is probably the biggest casino in that region (based on number of visitors). Of all the five licenses currently trading in that region, Sun International operates only one, while the others are operated by different players. 80

81 Figure 116. Kwazulu-Natal market [Rand Million] Kwazulu-Natal City Operator Population size 10.3m Capital Investment Number of visitors Slots Tables Square Footage (000s) Suncoast Casino and Entertainment Wor Durban Tsogo Sun gaming 1, ,600,000 1, Sibaya Casino & Entertainment Kingdom Durban Afrisun KZN pty ltd 1, ,959, n/a Tusk Umfolozi Casino Empangeni Emanzini Leisure Resorts , Century Casino New castle Balele Leisure , Golden Horse Casino Pietermaritzburg Akani Msundisi ,628, n/a Source: Citi Investment Research and CASA North-West The North-West market is spread amongst four licences, which are split equally between Sun International and Gold Reef Casinos. Sun International operates the two largest casinos (Sun City and Carousel) in the North West region. Within the casino segment, four licenced casinos operate in the North-West. The unlisted casino operator, which competes with Sun International, is Peermont 33. It owns/operates two casinos in the province. Figure 117. North-West market [Rand Million] North-Wes t City Operator Population size 3.3m Capital Investment Number of visitors Slots Tables Square Footage (000s) Tusk Mmabatho Mmabatho Tusk Resorts Pty , Sun City Pilanesburg Sun International ,500, n/a Tusk Rio Hotel Klerksdorp Tusk Resorts Pty , Carousel Hammanskral Sun International , n/a Source: Citi Investment Research and CASA Eastern Cape Sun International currently owns two of the three licenses issued in the Eastern Cape. The third one is held by Tsogo Sun Gaming. Figure 118. Eastern Cape market [Rand Million] Eastern Cape City Operator Population size 6.5m Capital Investment Number of visitors Slots Tables Square Footage (000s) The BoardWalk Port Elizabeth Emfuleni Resorts ,021, Hemingw ays Casino East London Tsogo Sun gaming ,300, n/a Wild Coast Sun Bizana Transkei Sun International , n/a Queens Casino Queenstow n Lukhanji Leisure n/a Source: Citi Investment Research and CASA 33 Peermont was de-listed in

82 Mpumalanga Sun International has no presence in Mpumalanga. Only two casinos operate in that region, Tsogo Sun and Peermont Global. All in all, the province is fairly negligible, with overall market share of only 4%. Figure 119. Mpumalanga market [Rand Million] Mpumalanga City Operator Capital Investment Number of visitors Slots Tables Square Footage (000s) Population size 3.6m The Ridge Witbank Tsogo Sun gaming ,400, Graceland Hotel & Casino Secunda Peermont Global ,076, Emnotw eni Casino Nelspruit Tsogo Sun gaming ,300, n/a Source: Citi Investment Research and CASA 82

83 Hotels South African Market Conditions Industry in good shape ahead of 2010 Soccer World Cup Foreign tourist arrivals in South Africa remain strong. Since 1994, when South Africa had its first Democratic Elections, foreign tourist arrivals increased from c. 4 million per year to just over 8 million (see Figure 120). Tourist arrivals reached 9.1 million in 2007 and could potentially reach 10 million tourists by This will be aided by South Africa hosting the FIFA Confederation Cup in 2009 and the FIFA Soccer World Cup in Figure 120. Foreign Tourist Arrivals ( ) Source: Citi Investment Research, South African Tourism and StatsSA South Africa s 8.3% growth of foreign tourist arrivals recorded in 2007 exceeded the global average growth rate of 6.6% and shifted South Africa from 29 th to 28 th position in global tourism destination. However, South African Tourism is cautiously optimistic about foreign visitor arrivals growth in the short to medium term as the country gears up for Tourist arrivals are expected to grow, but at a slower rate than previously. This view is largely in line with World Travel Organisation s forecast that global growth will soften over the next two to three years. Hotel Demand/Supply Analysis The following chart depicts the growth in hotel room demand versus supply in South Africa. In general growth in demand has been outstripping supply, as measured by the percentage increase in number of hotel rooms. We anticipate this trend to continue given an increasing number of foreign tourist arrivals into South Africa and the sound economic growth. During periods of high volume of demand, hotels should be able to raise room rates, hence leading to an improvement in profitability. 83

84 Figure 121. YoY % Change in occupancy rates vs. YoY % change in number of rooms South African Hotel Industry 35% 30% Rugby World in South Africa 2010 Soccer World Cup??? 25% 20% 15% 10% 5% Hotel demand to remain stronger than supply for the next 3 yrs Survey discontinued in Feb 2004 and continued in Sep % -5% Nov-90 Nov-91 Nov-92 Nov-93 Nov-94 Nov-95 Nov-96 Nov-97 Nov-98 Nov-99 Nov-00 Nov-01 Nov-02 Nov-03 Nov-04 Nov-05 Nov-06-10% -15% Demand Supply Source: Citi Investment Research and I-net ARRs and occupancies More Room for growth With foreign tourist arrivals increasing in South Africa and business tourism also trending upwards, demand has outpaced supply. Occupancies have held at c70% plus for key South African cities (Cape Town, Durban, Johannesburg and Pretoria). The average industry hotel occupancy rate since October 2004 (based on the new survey) is around 66%. Cape Town has the highest ARRs of all the key cities in South Africa, while Durban and Pretoria offers the cheapest rates. While the demand-supply gap will ultimately determine ARRs, we believe that the risk of ARRs declining is somewhat limited. Figure 122. South African Hotel Performance (ARRs and Occupancies) 2005 vs Occupancy ARR RevPAR 2005 % Change 2005 ZAR % Change 2005 ZAR % Change South Africa 69% Cape Town 70% Durban 75% Johannesburg 69% Pretoria 71% Source: HotelBenchmark Survey by Deloitte 84

85 Hotel companies expected to scale up Leading towards the FIFA Soccer World Cup in 2010 and the robust industry prospects of the South African hotel industry in general, we would expect to see most of the companies in the hotel & leisure industry scaling up. Already, most companies have announced their plans to increase their number of hotel rooms in South Africa. Despite the expected increase in supply, we would expect the demand to continue exceeding supply given the intact fundamentals in the sector (i.e. sound economic growth and a growing number of foreign tourists into South Africa). Figure 123. Protea Hotels at a glance 2007 Number of rooms 6,500 Number of employees: SA 10,000 Source: Citi Investment Research Protea hotels indicated that its target is to build 28 to 30 hotels in the next three years. Protea Hotels is Africa s largest and leading hotel group, owned by Australian Hospitality Group, Stella. Protea Hotels offers three and four star hotels across Africa. However, rising land costs could push back some supply The lower interest rates and the increased household disposable income in South Africa have led to an increase in property prices. This has also aided in pushing up the project costs of building hotels. Sun International property portfolio Below, we highlight Sun International s hotels at its different properties. Figure 124. Sun International Hotels at different casino properties Casino Hotel No of Rooms Grading Carnival City Casino & Entertainment World Carnival Club Hotel 48 Flamingo Casino n/a n/a n/a Gaborone Sun Gaborone Sun Hotel 196 ***** Golden Valley Casino Golden Valley Lodge 98 *** GrandWest City Casino & Entertainment World GrandWest's 4 star Grand Hotel 39 **** Kalahari Sands Hotel & Casino Kalahari Sands Hotel 173 **** Lesotho Mountain Kingdom Lesotho Sun 192 ***** Letsatsi Casino Cresta Botsalo Hotel 51 n/a Marang Casino Marang Hotel 58 *** Maseru Sun Maseru Sun 112 n/a Menateng Casino Cresta Bosele 50 *** Meropa City Casino & Entertainment World n/a n/a n/a Morula Casino and Hotel Morula Hotel 73 *** Naledi Hotel & Casino Naledi Sun Hotel 30 n/a Royal Swazi Spa Valley Royal Swazi Spa Hotel 149 ***** Ezulwini Sun 60 ***** Lugogo Sun 202 **** Sibaya Casino & Entertainment World Royal Sibaya Hotel 36 ***** Sibaya Lodge 118 *** The Boardwalk Casino & Entertainment World Beach Hotel 58 **** The Carousel Casino & Entertainment World Carousel Hotel 57 **** Sun City Entertainment Centre The Palace of the Lost City 338 ***** Cascades Hotel 243 ***** Sun City Hotel 340 **** Sun City Cabanas 380 *** Wild Coast Sun Wild Coast Sun Hotel 246 *** Windmill Casino & Entertainment World Windmill Lodge 80 n/a Source: Citi Investment Research and Company reports 85

86 Appendix A EBITDA Margin Comparisons Figure 125. EBITDA Margin Comparison Casinos in South Africa 60.0% 50.0% 40.0% EBITDA margins **Gold Reef EBITDA magins are quoted before rentals (EBITDAR), hence good margins The survey covers all the Casinos in South Africa and some in Neighbouring countries, but excludes Tsogo Sun Gaming Casinos due to lack of disclosure. Peermont FY07 group EBITDA margin 37.9% Gold Reef FY07 group EBITDA margin 41.4% Sun International group FY07 EBITDA margin 33.2% Tsogo Sun Gaming FY07 EBITDA margin 30.0% 20.0% 10.0% 0.0% Garden Route Casino** Golden Horse Casino** Goldfields Casino** Mykonos Casino** Tusk Rio GrandWest Windmill Meropa Boardwalk Emperors Palace Gold Reef City** Flamingo Carnival City Tusk Umfolozi Table Bay Sibaya/Sugarmill Silverstar** Golden Valley Carousel Tusk Venda Tusk Mmabatho Botswana Botswana Namibia Zambia Graceland Morula Wild Coast Queens Casino** Lesotho Bethlehem Sun City Swaziland Mondazur Source: Citi Investment Research and Co reports 86

87 Appendix B The Impact of Rising Rates on Individual Stocks The following charts should be read jointly with a section titled Wagering in an Economic Slowdown on page 17. In this section, we have analysed the relative performance of individual casinos (both Sun International and Gold Reef) during and after the rising rate cycles. Figure 126. Sep 94 Sep 97 rising rates cycle Sun Int l rel FINDI against Prime Interest reate Figure 127. Jun 98 Sep 98 rising rate cycle Sun INt l rel FINDI against Prime Interest rate % Jun Aug Oct Dec Feb Apr Jun Aug Oct Dec Feb Apr Jun Aug Oct Dec Feb Apr Jun Aug Oct /7/98 6/14/98 6/21/98 6/28/98 7/5/98 7/12/98 7/19/98 7/26/98 8/2/98 8/9/98 8/16/98 8/23/98 8/30/98 9/6/98 9/13/98 9/20/98 9/27/98 10/4/98 10/11/98 10/18/98 10/25/98 11/1/98 11/8/ RPOR[CL] (SUI[CL])/(J213[CL]) RPOR[CL] (SUI[CL])/(J213[CL]) Source: Citi Investment Research and Inet Source: Citi Investment Research and Inet Figure 128. Jan 2002 May 2003 rising rate cycle Sun Int l rel FINDI against Prime Interest rate Figure 129. Jan 2002 May 2003 rising rate cycle Gld Reef rel FINDI against Prime Interest rate /13/02 2/13/02 3/13/02 4/13/02 5/13/02 6/13/02 7/13/02 8/13/02 9/13/02 10/13/02 11/13/02 12/13/02 1/13/03 2/13/03 3/13/03 4/13/03 5/13/03 6/13/03 7/13/03 8/13/03 9/13/03 10/13/03 11/13/03 12/13/ /13/02 2/13/02 3/13/02 4/13/02 5/13/02 6/13/02 7/13/02 8/13/02 9/13/02 10/13/02 11/13/02 12/13/02 1/13/03 2/13/03 3/13/03 4/13/03 5/13/03 6/13/03 7/13/03 8/13/03 9/13/03 10/13/03 11/13/03 12/13/ RPOR[CL] (SUI[CL])/(J213[CL]) RPOR[CL] (GDF[CL])/(J213[CL]) Source: Citi Investment Research and Inet Source: Citi Investment Research and Inet 87

88 Figure 130. Jun 2006 Jul 2008 (current) Sun Int l rel FINDI against Prime Interest rates Figure 131. Jun 2006 Jul 2008 (current) Gold Reef rel FINDI against Prime Interest rates /8/06 3/8/06 5/8/06 7/8/06 9/8/06 11/8/06 1/8/07 3/8/07 5/8/07 7/8/07 9/8/07 11/8/07 1/8/08 3/8/08 5/8/ /8/06 2/8/06 3/8/06 4/8/06 5/8/06 6/8/06 7/8/06 8/8/06 9/8/06 10/8/06 11/8/06 12/8/06 1/8/07 2/8/07 3/8/07 4/8/07 5/8/07 6/8/07 7/8/07 8/8/07 9/8/07 10/8/07 11/8/07 12/8/07 1/8/08 2/8/08 3/8/08 4/8/08 5/8/08 6/8/08 7/8/ RPOR[CL] (SUI[CL])/(J213[CL]) RPOR[CL] (GDF[CL])/(J213[CL]) Source: Citi Investment Research and Inet Source: Citi Investment Research and Inet 88

89 Appendix C Provincial Tax Rates Figure 132. Provincial tax rates Province Provincial Casino Revenue Tax Rates Gauteng 9.0% North West 3.0% Northern Cape 8.0% Mpumalanga 5.7% Limpopo 6.0% Free State 7.0% Kwazulu-Natal Taxable revenue (Millions) Rates of Tax 30 9% >30 12% + 0.5% local government levy Eastern Cape Taxable revenue (millions) Rates of Tax 0-4 3% % > % Western Cape Taxable revenue (millions) Rates of Tax % R % R1.45m + 11% R2.25m + 13% R3.85m + 15% >50 R5.35m + 17% Source: Citi Investment Research and CASA 89

90 With Thanks to Marco de Matos Appendix D Gambling Survey - It s all about the Gambler The National Centre for the Study of Gambling compiled a national prevalence report (2006), for which a total of 3,003 respondents in Gauteng, Western Cape, and Kwazulu-natal were surveyed. According to the centre, gambling is defined as staking something valuable in the hope of winning a prize where the outcome is unknown to participants. Included in their definition is playing the lottery, bingo, charity jackpots in newspapers, fafi, scratch cards, casino games and betting on horses as well as other sporting events. The study showed that the lottery is much more accessible to poorer people, both in terms of geography and price, whereas slot machines are seemingly relegated to the higher-income groups. This could be due to a number of factors, including the entrance fees charged by casinos and the fact that most casinos are not as easily accessible, i.e transport costs to and from casinos and also the cost of food and drinks at these casinos, while the lottery is easily accessible and lotto can be purchased from a multitude of venues throughout the country. We highlight the following key points: Of the 3,003 respondents in the 2006 survey, 86.9% had played the lottery, while only 27.7% played slots. 52.5% gamble regularly (i.e. once a month or more only on the lottery), while 33.6% gamble regularly (once a month or more) on categories other than the lottery. In terms of frequency of gambling activity 8.3% (down significantly from 20.1% in 2003) never gamble, this very high decrease in non-gamblers is likely due to gambling activity being much more accessible than what it was a few years ago with the introduction of the Lotto and increased number of casinos On average individuals spend R81.30 per month on the lottery, while on slots, roulette and cards (all casino related games) an average monthly spent is R541.00, R and R493.70, respectively. Although a very high number of people play the lottery, the expenditure on slots far outweighs that which is spent on the lottery but this amount is spent by a smaller percentage of individuals than in the case of the lottery, which is much more broadly based (refer to figure 134 below). As general exposure to gambling has increased over the past few years, the survey found that the percentage of conventional gamblers has decreased. However, gambling in general has increased as mentioned above. Excluding the Lottery and Slots, the remainder of participants was divided into 22.7% Scratch-cards; 11.6% newspaper jackpots, 11.5% horses, and the remaining gambling activities, which included Fafi, Bingo, Dice, Roulette, Cards and Sport betting, made up less than 6%. 90

91 Figure 133. Participation percentages of gambling activities, 2005 Figure 134. Monthly Gambling Expenditure, % 80.0% 86.9% R R R R R R % R R % 20.0% 27.7% 22.7% 11.6% 11.5% 11.5% 5.8% 5.3% 4.2% 3.9% 3.0% 2.8% R R R R R R R R R % Lottery Slots Scratchcards Jackpots Horse Racing Horses Fafi Cards Roulette Sports Bingo Dice R 0.00 Slots Spend Cards Horses Roulette Dice Sport Lottery Bingo Fafi Scratch Jackpots Source: Citi Investment Research and National Centre for the study of Gambling Source: Citi Investment Research and National Centre for the study of Gambling Analysis of monthly Gambling Expenditure Gambling Spend We had a look at a survey compiled by the National Centre for the Study of Gambling in conjunction with the National Gambling Board. The survey reveals that although lottery is played by a large proportion of the people, expenditure on slots far outweighs that on the lottery, but is expended by a much smaller proportion of people. Figure 135. Analysis of monthly Gambling Expenditure, 2005 [Rand Millions] Game Total Rand spend in sample No of spending any money on game Average spend per month % of total gaming spend Jackpots % Scratch % Fafi % Lottery % Bingo % Dice % Roulette % Card % Slots % Horse % Sport % Source: Citi Investment Research and National Centre for the Study of Gambling Gross gaming revenue growth has so far been driven by the consumer, who has benefited a lot from lower interest rates (in South Africa) and higher overall real income growth. Although regular gambling appears to be quite independent of income, we highlight that wealthier individuals are more likely to gamble on slots and roulettes (tables) than lower-income earners (lower end of the household consumer spends more money on lottery). 91

92 Participation in gambling activities can be either regarded as a leisure activity, or an urge to take up risks and tempt fortune or a combination of both. This is true for casinos gambling. Buying of lottery tickets is exclusively aimed at winning. Who are the Casino Gamblers? Given the fact that casino gambling dominates the other different forms of gambling, it is interesting to know who the gamblers are. We also try to figure out the characteristics of a typical casino gambler. According to the national gambling board, three in five households buy lottery tickets twice a week, followed by a further 24.5% that buy lottery tickets once a week. The National Lottery is by far the most popular gambling mode in South Africa. Just more than seven in every ten South Africans procured lottery tickets, while only two in ten visited casinos. Gambling s Economic Effect The economic impact of the gambling industry on the economy is determined by the: Initial impact, measured as the direct spending of gambling institutions. Indirect impact, resulting from additional activities of suppliers (e.g. additional bricks, cement and trusses that are manufactured with the building of a new casino). Induced impact on the economy due to the increased demand for goods and services by households on the strength of the remuneration earned due to the establishment of, say, a casino. Total impact = initial + indirect + induced impacts (the initial impact can be regarded as the actual contribution of the gambling sector). Gambling taxes boost government revenues through gambling taxes. 92

93 Appendix E: Shareholder Structure Figure 136. Gold Reef Shareholding Structure, As at December 2007 Figure 137. Sun International Shareholding Structure, As at June 2007 Prime Portfolio Investments 1% Monja Schutte 1% Old Mutual 1% Broker Proprietary 1% Other 21% Old Mutual 5% JP Morgan Chase 5% State Street Bank 4% Sanlam 3% RE:CM 2% RMB 2% Morgan Stanley 2% BJ Schutte 1% Benita Schutte 1% Casinos Austria 21% Allan Gray 37% Mellon Bank 2% Coronation 1% Steven Joffe 2% Newshelf 2% Clidet 2% Platoon Trade and Invest 3% Mark Krok 3% BMF 3% David Krok 4% Simone Lerman 4% Elana Pincus 4% Shelly Krok 4% Maxim Krok 5% Saddle Path 5% Aldiss Investmetns 5% Broker Proprietary 5% Other 37% Source: Citi Investment Research and company reports Source: Citi Investment Research and company reports 93

94 Appendix F Casino 101 and Revenue Flows In casino revenue accounting, the key definition is that of win, defined as the total amount of casino income. It is also defined as gross gaming revenue. It should be stressed that win is the net amount of win after all winning wages have been paid. The concept of win is similar to that of net sale revenue for a commercial business. Win can also be defined as the difference between the total amount wagered or played and the amounts repaid to winners, alternatively, Win = Drop minus Payout A second definition of use in understanding casino revenue flows is that of drop. Drop is a measure of the total wagering activity in a casino. The term is reserved for table games. When used in connection with a slot machine, drop is the number of coins in the collection bucket located under the slot machine and is called the slot drop. A closely-related concept in slot machines is the handle, which measures the total amount of money deposited into a machine. However, in the case of table games, the winning and losing bets are determined by the dealer; either the winners are paid or the losing bets are collected. The losing bets are returned to the table tray, if the bets were placed in chips, or are deposited in the drop box for bets made with something other than chips. There is no effective way to measure the total wagering activity, and only the net effect of the wagering that is, the win can be measured. In this situation, the drop cannot be accurately determined. A figure below provides a guideline of the revenue flow in the casino. 94

95 Figure 138. Typical Revenue Flow chart in the Casino Source: Citi Investment Research and Industry Sources 95

96 Appendix G South African Casinos Summary 96

97 Figure 139. Summary of Casinos in South Africa Source: Citi Investment Research and CASA 97