Quarterly Strategy Note July 2016

Transcription

1 Quarterly Strategy Note July 2016 Richard Hasson & Neil Brown Co-Heads Electus Update on Research and Fund Management and our Business Now that Electus has been operating for a year as an independent FSP on its own FAIS Licence, it seems appropriate to update you on our Research and Fund Management and our Business. Research and Fund Management As we previously advised you, we recruited four new colleagues into Electus in August 2015, two of whom, Tali Anderssen and Kelly Fransman, manage all of Electus operational aspects and two of whom, Damon Buss and Mishal Emeran, joined the two of us as South African (SA) equity analysts. Damon and Mish-al each have >5 years of experience as SA equity analysts. Since August 2015, Electus has had this four person strong SA equity analyst team, analysing ±110 SA listed companies. Between August 2015 and January 2016, the four of us completed our research coverage of the above ±110 companies, with industry and company research, full financial modelling and company valuations, and this was all integrated into our FactSet research and data system. This has meant that since January 2016 the four of us have been working with a complete base of fundamental research, which is necessary for us to successfully compete in the SA equity segment of the asset management industry. An example of our thorough fundamental research is shown below, where Damon Buss has written about the SA Casino industry and its related shares, Sun International, Tsogo Sun and Hosken (HCI), that we analyse in this industry and own in our Client funds. Pleasingly for our Clients, for the first half of 2016, both our retail and institutional SA equity funds performed ahead of their respective benchmarks. Business With both of us having previously managed SA equity Hedge funds, from , we were keen to explore this area of investment, as it is entirely complementary to the Long Only funds that Electus currently manages. Both the Hedge and Long Only fund products only make use of the ±110 SA listed companies that we currently analyse, so no new research work is required by us. The key difference in these two products is that Hedge Funds can make much better use of shares that we believe are overvalued, through the shorting of them, which is not allowed in our Long Only funds. We have recently signed a Joint Venture (JV) Agreement with Peregrine Holdings for us to manage Hedge funds and we have started an SA equity long/short hedge fund. Peregrine is undoubtedly the market leader in the SA Hedge Fund industry, with vast industry and operational experience and we also have a very long-standing relationship with them and their key management. This new Electus hedge fund is >R100m and has been operational since 1st July Electus has recently completed its first set of annual audited financial results and pleasingly the business was nicely profitable and the bank balance is very healthy. This is an important fact as Electus is a young and independent asset management company, and confidence in the Electus team and business plays an important role in future success. Summary As can be seen from the above the Electus business has successfully, and profitably, completed its first year as an independent business and is also making good strides in terms of delivering solid fund performance and the launching of complementary products. SA CASINO SHARES WORTH THE BET DESPITE THE SHORT TERM HEADWINDS South African (SA) Casino shares, which are also referred to as Gambling or Gaming businesses, have been under pressure over the last 18 months. This has been due to a combination of very poor sentiment (consumer and business) and an increasingly tough consumer environment in South Africa, restricting industry gross gaming revenue (GGR) growth to low single digits. This has resulted in SA casino shares trading near levels last seen during the Global Financial Crisis in The 12 months forward Price Earnings (P/E) multiple of an equally-weighted composite index of SA listed companies Tsogo Sun and Sun International de-rated from 15.5x in December 2014 to a low of 9.9x in January 2016 (see chart 1), which was an attractive level for buying the shares relative to where they have traded in the past. Whilst there has been some recovery to the current 10.9x, we still believe both shares offer good value at their current prices. 1

2 Chart 1: Gaming index Price Earnings multiple (x) Chart 4: Dividend Yield (%) Source: Factset, Index an equally weighted composite of Tsogo Sun and Sun International, Electus analysis On a Price Earnings Relative (PER) multiple (relative to JSE SWIX, see chart 2) the gaming sector has underperformed since the euphoria of the FIFA Soccer World Cup abated towards the end of 2010, a period in which the rand hedge stocks have been the key drivers of the index, whereas the casino shares are predominantly Rand earners. Chart 2: Gaming index Price Earnings Relative multiple (x) Source: Factset, Electus analysis What makes casino companies good businesses to invest in? 1. Gross Gambling Revenue (GGR) growth is more resilient than people expect, growing strongly (high single/low double digits) in good times and slowly in poor times (mid-low single digits) (see chart 5). Whilst casino based gambling has entered the mature phase of industry growth, as has Horse Racing betting (a part of Betting in chart 6), other gambling modes (e.g. Limited Payout Machines (LPM), Electronic Bingo Terminals (EBT) and Sports Betting) are just starting to ramp up (see chart 6). Chart 5: Gross Gaming Revenue all modes Source: Factset, Index an equally weighted composite of Tsogo Sun and Sun International, Electus analysis Another key valuation metric on which gaming companies globally are measured is Enterprise Value (EV, market cap plus debt minus cash and cash equivalents)/ebitda (i.e. earnings before interest, corporate taxes, depreciation and amortization). Given the heavy capital expenditure required in building casino complexes, as well as the use of debt to fund these projects, EBITDA is a fairly clean measure to compare casino business operations, independent of capital structure. Earlier this year both Tsogo Sun and more so Sun International were looking cheap relative to their history (refer to chart 3). Whilst they have recently re-rated slightly, they remain well below the 9.0x-13.0x level that their global peers trade at, yet they deliver higher EBITDA margins and are forecast to have higher revenue growth. Chart 3: Company Enterprise Value (EV)/EBITDA (including mean and standard deviations) Source: Factset, Electus analysis A final relevant valuation methodology we use for gaming share analysis relates to the dividend yield. Dividend yields, based on the last 12 months for both Tsogo Sun and Sun International are currently 3.5% and 3.1% respectively (refer to chart 4) which is marginally better than what can be earned on the overall dividend yield of the JSE SWIX of 3.0%. Source: Casino Association of SA (CASA), Electus analysis Chart 6: Contribution to Gross Gaming Revenue by gambling mode Source: CASA, Electus analysis The legalisation and introduction of LPM s and EBT s are taking market share away from the traditional casinos, as they offer the marginal gambler an alternative (See chart 6). Sun International has acknowledged this threat by deciding to purchase a 75% stake in Grand Parade Slots, whilst Tsogo Sun still believes these new gambling forms are not attractive to the traditional gambler, hence they have no exposure. However, investors do have the option of purchasing Hosken Consolidated Investments (HCI) who have a 43% effective holding in Tsogo Sun and a 52% stake in Niveus (NIV), which owns 100% of Vukani Gaming (LPM s) and Galaxy Bingo (EBT s). 2. Casino businesses have moats (i.e. a competitive advantage) due to requiring licences to operate, enabling them to deliver good Returns on Equity (ROE), an indicator of a high 2

3 quality business model. In 1996 gambling was legalised in South Africa, with the National Gaming Board (NGB) deciding on a maximum of 40 licences (38 of which are active today). The NGB opted for an exclusivity policy, rather than the Las Vegas strip style policy, which provides each casino licence an area of exclusivity around its location, in exchange for a fee (i.e. ongoing gaming taxes, as well as some form of Corporate Social Investment spend upfront when the licence was allocated). A key benefit is that all except the Eastern Cape licences (5 in total) are evergreen licences, hence unless the limit of 40 national licences is increased (unlikely and will be vehemently opposed by the incumbents), there will be no new competitors which can unseat Sun International and Tsogo Sun. 3. Leverage most operating costs are fixed, i.e. whether there is one gambler or ±7 gamblers (i.e. full) at a table you still need a dealer, security and the lights on. Therefore, the operational performance of the companies is really determined by how they grow their revenue. Table 1 illustrates that with a growth assumption of 8.5% for revenue (conservative relative to the 11% long-term average as per chart 5) and 7.0% for costs over the next 5 years, combined with the reduced debt burden (i.e. interest cost) due to the strong cash flows that casinos generate, the Net Profit will grow by a healthy 22.1% per annum. Table 1: Gearing example CAGR* Gross Turnover % - total money made from customers Net Turnover less gaming taxes & VAT (±25% of gross sales) Operating costs (40.0) (56.1) 7.0% - staff, electricity, security, etc EBITDA % EBITDA margin 35.0% 37.7% Interest (10.0) (6.0) - casinos are typically built with large portion of debt, which is paid down quickly due to strong cash flows Depreciation (10.0) (10.0) - on buildings & equipment Tax (4.2) (11.4) - SA corporate tax rate is 28% Net Profit % - this would be the earnings reported * CAGR - compound annual growth rate over 5 year period ( ) This high operating leverage can also be a negative though and explains the recent poor performances from both Sun International and Tsogo Sun, as gaming revenue growth has slowed. Yet, the value of the gaming companies lies in the fact that their current reported net profit is a poor reflection of their true earnings power. As both have had large capital expenditure programs in SA which will peak in the next 6 to 12 months, after which their free cash flow can be spent paying down the debt which funded the property expansions, refurbishments and new developments. Food and Beverage, etc.) do dilute the group margins, they are not as capital intensive as the casino operations, so their impact on returns is more muted. The key drivers of gaming businesses are at cyclical lows. Ultimately the performance of a casino is determined by two things footfall (i.e. frequency of visits) and spend per visit. For a casino complex to attract footfall it needs to provide a more attractive and entertaining destination for the consumer than other forms of entertainment (i.e. predominantly malls) in its catchment zone (±25km radius). The SA casino businesses have done a very good job of creating entertainment complexes (e.g. Montecasino in Fourways and Grandwest in Cape Town) that provide activities for the entire family (i.e. movies, arcades, shops and restaurants), which fulfil the dual role of attracting people to the properties, whilst also allowing the gambler to spend more time on the gaming floor. Well-educated (tertiary), high net wealth (LSM 9-10) individuals between the ages of account for approximately 20% of the South African casino industry s customers, yet this core group delivers ±80% of gaming revenues. The key for the gaming businesses is to grow this pool of customers, something that should become easier due to the impending demographic change in SA, as the core gambler market (i.e. people in the peak spending phase of their lives, deemed to be ages 30-60) is set to grow significantly over the next 15 years (see chart 7), whilst the hunt for jobs will continue to drive urbanisation (where the main casinos are located). Chart 7: Population in core gambling age bracket set to grow considerably 4. The high operating margins (can generate ±40% EBITDA margins) mean casino businesses generate significant and relatively stable operating cash flows, which affords them the ability to leverage their balance sheets and hence, consistently deliver ROE s that are substantially above their cost of capital. While the hotel and other operations (i.e. 3

4 What the casino businesses cannot influence though, is how much money a gambler decides to spend when visiting the casino, as this is rather determined by a combination of the consumers affordability (i.e. how much they can spend) and more importantly, their sentiment (i.e. how wealthy/exuberant they feel and therefore how much they do spend). While the SA consumer is currently under strain, it is important to note that over the last 13 years Household Consumption Expenditure (HCE) growth, which is a measure of consumers income, averaged 9.5% in nominal terms or 4.5% in real terms (i.e. inflation adjusted). Over the same period, the propensity to gamble in SA has been stable, as shown by the blue shading in chart 8 below where GGR as a % of HCE has consistently been around 1.0% (see chart 8). Hence HCE growth is a good proxy for GGR growth. Given that long term future inflation is expected to remain close to the top end of the SA Reserve Bank s target band of 3.0% to 6.0% (real), it s reasonable to expect nominal HCE growth, and therefore GGR growth, to average between +7.5% and +10.5% (nominal) per annum in the medium to long term. Chart 9: Sentiment factors for gaming spend Chart 8: The propensity to gamble Source: Factset, CASA, Electus analysis The divergence between GGR growth and HCE growth can largely be explained by changes in consumer sentiment (i.e. how wealthy and exuberant they feel). Despite the brief reprieve during the 2010 Soccer World Cup, consumer confidence has steadily deteriorated post the Global Financial Crisis (see chart 9) and whilst it remains negative, it appears to be past the trough of early 2015 and is trending upwards. Two important drivers of the core gambler markets confidence are house prices (often the biggest asset on personal balance sheets) and business confidence (business performance drives wealth creation). As can be seen in chart 9, prices of large houses have steadily improved since early 2009 (positive for GGR), however business confidence has trended downwards (negative for GGR) and is only slightly above the trough GFC level. Source: Factset, Electus analysis The key risks to our positive view on the industry are: Smoking ban a number of countries globally have implemented strict regulations on where smoking can occur in public spaces, effectively outlawing the glassed-off smoking section in any building that the general public use (i.e. bars, restaurants, casinos, airports, etc.). This is important for casinos as approximately 60% of GGR comes from the smoking section and the experience of Australia and Chile have shown GGR can fall by as much as 20% post implementation of the smoking ban and take up to 18 months to recover to pre-ban levels, once special smoking areas have been developed. We expect SA to enact this smoking ban legislation within the next 5 years, however the impact should be more muted than the global experience as the complexity of the legislation will provide enough time between announcement and final implementation for Sun International and Tsogo Sun to adapt their properties, based on the best solutions already developed by their global peers, to comply with the SA regulations. 4 Tax increases given the sin social tag, the gaming industry is an easy target for Provincial Governments to frequently squeeze out more tax revenue. However, the industry is the second largest contributor to provincial tax

5 receipts (±16% of provincial tax income) and provides significant employment opportunities, two factors which should restrain the provinces from pushing taxes to levels which deter further investment. Why we believe it is a good time to buy SA gaming shares The underperformance of the gaming shares over the last 2 years has largely been caused by the concerns around the pressure on consumer expenditure, which has been squeezed by lower real wage growth and increasing inflation, and the very negative sentiment. What seems to have been ignored is that the pressure on consumers is more in the low-mid LSM groups and less so in the high LSM groups and hence the slowdown in GGR is due to a reduced willingness to spend, more so than a reduced ability to spend. Despite the low economic growth environment we face, we believe the sentiment of these high income consumers will continue to improve and therefore GGR growth should be reasonable, as we move past the recent Rand weakness, the peak of local inflation, the uncertainties created by the forthcoming elections (both local and global) and the decision on SA s credit rating (December 2016). Whilst the market has been focusing on these external drivers, as shown below, both Sun International and Tsogo Sun have finalised or are completing numerous initiatives to improve their own businesses, which we believe will assist the companies top line growth to exceed HCE growth in the short to medium term: Tsogo Sun very good management with the best quality assets - Refurbished and expanded some of their key properties - acquired approval to increase the number of Gauteng gaming positions by 30% (the 3 Gauteng properties contribute ±54% of Tsogo Sun s gaming revenue) and they are about to start the doubling of Suncoast (Tsogo Sun s 2nd biggest casino situated in Durban, which contributes ±19% of gaming revenue) - Substantially growing the other revenue sources of the group, namely the hotel division (occupancies steadily increasing while average daily rate growth has been well above inflation) and internalising the Food and Beverage businesses (captures more of the profits generated within the casino complexes) - Starting the process to unlock the value of its property portfolio through shifting the non-gaming properties into the recently acquired Hospitality REIT (Real Estate Investment Trust) - Refocused the business on gaming (i.e. the highest margin division) and acquired approvals to replace Morula (a peri-urban casino situated in Mabopane on the Gauteng/North West border delivering R33m EBITDA in FY15) with Menlyn Maine (an urban casino situated in Pretoria s affluent Menlyn suburb which should deliver >R600m EBITDA once fully operational in FY19) - Have brought a substantial portion of the Food and Beverage businesses in-house (captures more of the profits generated within the casino complexes) - Have sold off the under-performing African operations, with the exception of the Nigerian hotel and casino complex which will they are actively looking to exit - Have created the largest gaming business in Latin America (majority of assets in Chile, but also exposed to Colombia, Peru and Panama) by completing the joint venture deal with the Chilean based Dreams group. Importantly gaming has only been legalised relatively recently in these countries and hence the casino industry still has significant growth ahead of it In addition both Sun International and Tsogo Sun have been able to largely maintain their margins during this period (see chart 10), hence they should get substantial gearing (as illustrated in table 1 earlier) when GGR improves. It is important to also note that SA casino shares have margins that are higher than the 25% average margins delivered by USA Regional Casinos (similar competitive landscape to SA casino industry), businesses currently trading on higher multiples than both Sun International and Tsogo Sun. Chart 10: Source: Company reports, Electus analysis. Note: Sun International hasn t reported FY16 numbers yet Summary We have taken positions in Client funds in Sun International (Electus fair value of R140/share, 65% upside) and HCI (Electus fair value of R231/share, 90% upside) as a cheap entry point for Tsogo Sun exposure (Electus fair value of R38/share, 29% upside). Sun International new, highly regarded, management (CEO and CFO) reinvigorating the business - Completed a significant cost cutting exercise, increasing EBITDA margins by 2.5% to 30.0% with ±1.0% more to come 5 We have taken exposure to Tsogo Sun through HCI, as HCI provides a cheaper entry point than investing directly into Tsogo Sun, as explained below: HCI is currently trading at R122/share, a discount of

6 ±36% to its Net Asset Value (NAV) if Tsogo Sun is valued at its current price, which is significantly greater than the long-term average 21% holding company discount to NAV that it has traded at over the last 6 years At the current Tsogo Sun price of R29/share, HCI s 43% effective holding in Tsogo Sun equates to R136/share of HCI s R191/share NAV. This means that we get exposure to Tsogo Sun at a price we believe undervalues the business, whilst getting a free option on all of HCI s other businesses (a combination of some mature businesses and some very small businesses with significant blue sky potential) Importantly, using our Electus fair value for Tsogo Sun of R38/share, HCI s NAV increases to R231/share of which Tsogo Sun accounts for R178/share. This means HCI is trading at a 47% discount to NAV, more than double the 21% longterm discount. These positions currently provide investors in our funds with exposure to: Quality business models that deliver high ROEs which stem from the moats created by casino licences Businesses with similar growth prospects to other domestically exposed businesses, but at more attractive valuations - On a Price Earnings multiple and a Price Earnings Relative basis (see charts 1 and 2) both stocks are significantly under-priced relative to their history - Whilst on Enterprise Value/EBITDA multiples (see chart 4) the shares look more fairly priced, as detailed above, current GGR growth and EBITDA margins are well below what normalised levels should be. As GGR growth improves and the operational gearing drives strong earnings growth, both companies will be able to pay down debt and therefore the Enterprise Value/EBITDA multiples should re-rate up towards the unlevered x range justified by the quality of the assets, the higher margins and the forecast revenue growth relative to global peers Attractive Dividend Yield and growth in dividends SA EQUITY MARKET VIEW Since our last Strategy Note in April 2016 the SA equity market has been broadly flat, with the Resource sector continuing it better performance which started in early 2016, while the Financial sector has been the laggard sector. We believe that most of the key equity market sectors are now fairly valued, with Financials being a bit undervalued. Pleasingly, as we also mentioned in April, we believe that in 2016 the SA equity market has been paying much greater attention to Valuation (not value ), and not to Momentum related criteria, which is totally aligned with our bottom-up methodology of investing. This is also positive for our Client funds as we build funds that are well diversified across key sectors, enabling us to seek to obtain excess returns for Clients from share selection and not from sector selection. From a macro perspective, the key issue that arose in the past quarter was the surprising Brexit vote in the UK Referendum on 23rd June. While it will probably lead to several years of business and market uncertainly between the UK and Europe, as well as slower economic growth, as we wrote in our July 2015 Strategy Note, we strongly believe that the European structure is fundamentally flawed, where there are 28 countries with a common monetary policy, but vastly different fiscal and taxation policies. As we build and manage diversified Client funds, and focus on bottom-up investing, we were broadly neutrally positioned leading into the UK Referendum and we did not position the funds for either a Remain or a Leave vote. In these more volatile financial markets the Resource sector has risen back to appropriate price levels, the Financial sector is slightly undervalued, while in aggregate, we believe that the SA equity market is now fairly valued. We believe that good share selection will be critical for success in the balance of 2016 and into 2017 and we therefore remain focused on investing in best-in-class businesses with zero tolerance for poor businesses that have high financial risk. Based on our Electus fundamental valuations, we have been able to identify several specific opportunities in the SA equity market, mainly in the Financial and SA Industrial sectors. This means that, in aggregate, the Client funds are extremely undervalued with current upside of >25%, which is a well above average number and very positive for the future. Therefore, we remain confident that the Client funds are well positioned. 6

7 Long-Term Performance History Nedgroup Investments Growth Unit Trust to Excess Return pa vs General Equity Peer Group Unit Trust of 1.5% Since managed by Neil Brown and Richard Hasson Source: Morningstar and Electus Electus Fund Managers Proprietary Limited (Reg No 2014/268056/07), an authorised financial services provider (FSP 46077) approved by the Registrar of Financial Services Providers ( to provide intermediary and advisory services in terms of the Financial Advisory and Intermediary Services Act, 37 of Electus Fund Managers Proprietary Limited ( Electus ) has comprehensive crime and professional indemnity insurance. For more detail, as well as for information on how to contact us and on how to access information please visit The content and information provided are owned by Electus and are protected by copyright and other intellectual property laws. All rights not expressly granted are reserved. The content and information may not be reproduced or distributed without the prior written consent of Electus. The content of this presentation is provided by Electus as general information about the company and its products and services. Electus does not guarantee the suitability or potential value of any information or particular investment source. Market fluctuations and changes in rates of exchange or taxation may have an effect on the value, price or income of investments. Since the performance of financial markets fluctuates, an investor may not get back the full amount invested. Past performance is not necessarily a guide to future investment performance. The information provided is not intended nor does it constitute financial, tax, legal, investment, or other advice. Nothing contained in the presentation constitutes a solicitation, recommendation, endorsement or offer by Electus, but shall merely be deemed to be an invitation to do business. Electus has taken and will continue to take care that all information provided, in so far as this is under its control, is true and correct. However, Electus shall not be responsible for and therefore disclaims any liability for any loss, liability, damage (whether direct or consequential) or expense of any nature whatsoever which may be suffered as a result of or which may be attributable, directly or indirectly, to the use of or reliance upon any information provided. CONTACT DETAILS: GREAT WESTERFORD BUILDING, 240 MAIN ROAD, NEWLANDS, CAPE TOWN 7700 TELEPHONE NUMBER: WEBSITE ADDRESS 7