Star Entertainment (ASX: SGR) owns and operates casinos in Sydney, Brisbane and the Gold Coast. Its Sydney property has historically provided most of the group's earnings but these have fallen since Crown was granted a Sydney license, ending Star's monopoly in the city.

Star's recent financial results were delayed by liquidity concerns and the company's shares were suspended from the ASX. The company subsequently secured fresh funding, published its numbers and returned to trading in volatile style.

Our Star Entertainment analyst Angus Hewitt recently sat down with me to discuss the Star's financial position, regulatory concerns, what markets want to see from the company, and whether the shares offer a big enough margin of safety. 

“The result itself was known. Everything else was worse…”

Joseph Taylor: So Angus, Star returned to trading and it was a volatile start. It fell very heavily. Was that an overreaction?

Angus Hewitt: The result itself was known. It wasn't good, but it was known and everything else was worse. So the incoming CEO, Steve McCann, described Star as a company that's clearly on its knees. That's pretty emotive language. Earnings have just collapsed since June, costs at the new Queen's Wharf Casino in Brisbane have blown out and that's leading to some liquidity issues at the moment. So the drop itself, we still think Star is undervalued, but the drop itself wasn't surprising.

Taylor: So you mentioned the liquidity issues. They've not tapped the equity markets yet. They went for an emergency, some emergency debt instead. Do you think they'll return to the equity markets for some funding at some stage?

Hewitt: Yeah, I think they'll probably just kick the can down the road. They've got a $200 million facility. The second half of that, the second tranche of that, requires them to raise $150 million in sub debt, which we think will probably just mean a capital raise.

“The result of the Bell inquiry was probably as good as Star could have reasonably hoped”

Taylor: Another big risk hanging over the company, liquidity aside, were doubts over its casino license. Are those largely in the rear view now?

Hewitt: No, those licenses are still very much in play. The Bell Inquiry, the second Bell Inquiry into Star's suitability to hold a casino license in New South Wales, handed down its final report. And that was probably as good as Star could have reasonably hoped. It still found that Star was unsuitable to hold a casino license, but it stopped short of actually revoking the license completely. And it's given them another chance. But they still need to prove suitability in New South Wales, and they still need to prove suitability in Queensland. But the near-term risk of having to shut the doors at Sydney has lowered.

“It was obvious that the regulatory spotlight was going to point to Star.”

Taylor: In addition to all of that, we’ve had COVID and we've also had a new competitor come into the Sydney market. We couldn't have predicted COVID, but could Star have positioned itself better for the threat of Crown?

Hewitt: Once the second license was handed to Crown, there wasn't a great deal that Star could have done. They have invested in their premium gaming rooms ahead of Crown opening. But I think what they probably should have focused on, so at the time Crown was dealing with its own suitability issues, and Star hadn't at that point. In hindsight at least, it would have been prudent to look at their own internal risk and compliance measures, and show that they too can return to suitability. Because it seemed obvious at the time, and in hindsight even more so, that the spotlight from a regulatory point of view was going to be pointed to Star eventually.

Taylor: So they no longer have a monopoly in Sydney, but in Queensland they're still the exclusive operator. How can Star act to protect that position?

Hewitt: So with the opening of the new Queen's Wharf casino, they were granted 25 year exclusivity in Brisbane. But I think even regardless of that, they've spent a lot of money on both the Gold Coast and the Brisbane casinos. And until casinos in Australia become radically more profitable, I don't see another competitor being interested in moving in and spending that kind of money anytime soon.

“There’s a lot of uncertainty... investors need a large margin of safety”

Taylor: So moving to the stock, it's obviously been very, very volatile recently. You still think it trades a long way below fair value. What do markets need to see for the volatility to calm down a bit and for the value gap to close?

Hewitt: There’s a lot of uncertainty. What the recovery of earnings looks like still remains to be seen. The AUSTRAC fine is still unknown. We think it's going to be about $330 million. It could be much higher than that. The outcome of the licenses in both New South Wales and Queensland remain to be seen, the impact of things like mandatory carded play, which is having a pretty big impact on earnings, at least immediately after it's been implemented, how that looks. So there's a lot of uncertainty and we think investors require a wide margin of safety. That said, we do think it is materially undervalued. What the market wants to see, and really what we want to see is a recovery of earnings. We think earnings are going to recover over the medium term. And there's a few things here.

So first is the cyclical downturn in discretionary spending that's weighing on main floor gaming. Second is temporary transition costs. So a lot of that in risk and compliance. A lot of those costs will roll off. And third is a much smaller part of the equation, but VIP gaming. We do expect VIP gaming to come back to levels much, much lower than it was pre-COVID. But we do expect it to come back to some extent over the next few years.

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The Star Entertainment Group (SGR)

  • Share price October 11: $0.26
  • Fair Value estimate: $0.67 per share
  • Uncertainty: Very High
  • Economic moat: None

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Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn more about how to identify companies with an economic moat, read this article by Mark LaMonica.

Uncertainty Rating: Morningstar’s Uncertainty Rating is designed to capture the range of potential outcomes for a company. An investor can think of this as the underlying risk of the business. For higher risk businesses with wider ranges of potential outcomes an investor should consider a larger margin of safety or difference between the estimate of what a share is worth and how much an investor pays. This rating is used to assign the margin of safety required before investing, which in turn explicitly drives our stock star rating system. The Uncertainty Rating is aimed at identifying the confidence we should have in assigning a fair value estimate for a stock. Read more about business risk and margin of safety here.