Sun International, founded in 1967 by Sol Kerzner, is an iconic South African business which boasts flagship assets such as Sun City, Time Square Casino in Gauteng and GrandWest in Cape Town. When the hospitality industry was severely impacted by lockdowns during the pandemic, we saw this as an opportunity to invest in Sun International at well below intrinsic value. In this article, Equity Analyst Muneer Ahmed unpacks our investment case for the company – looking back and looking forward.
Despite being open for business from June 2020, the impact of the Covid-19 pandemic was felt in the hospitality sector all the way till the end of 2021. The story of the pandemic is well told by now, but the chart below shows the impact of trading on income, month by month, for Sun International. Trading only really returned to some form of normality in early 2022.
Figure 1: Sun International income trend, month by month
Source: SUI results presentation 2021
In our view, early 2022 provided us with an opportunity to invest in a quality business, with a strong management team and solid growth prospects at a significant discount to its intrinsic value – which are all factors we look at as part of our investment philosophy.
Below we cover some of the factors we considered for our investment case.
The company quickly tackled its debt issues, paving the way for swift return to profitability.
An overleveraged balance sheet can be a problem at the best of times. It is certainly not what you want in a business at the worst of times. At the onset of lockdowns (early 2020), the group had gross debt of R12 bn. With no profit to show for the first six months of 2020, debt was a big problem. This was resolved through two important corporate actions:
1. A R1.2 bn rights offer
2. The sale of all their Latin American assets for $160 m. This acquisition had been a drag on returns, so the sale was a welcomed decision.
As a result of these actions, the balance sheet was in a much stronger position once trading resumed after mid-2020. This swift action to reduce debt and rightsize costs in the business was positive for our view on the management team. With debt at a more manageable level, we were comfortable buying the stock.
Once operations returned to some form of normality in 2021, the business returned to profitability very quickly with a break-even performance in the first half of 2021 and reporting a small profit for the full year. Despite revenue being well below pre-pandemic levels, a significant portion of the forced costs cut during the closures became permanent reductions. We saw this in many South African businesses with the pandemic forcing management teams to think differently about their business’ fixed cost base. The result of this is margins now trading ahead of pre-pandemic levels, as displayed in figure 2 below. Save for loadshedding costs, 2023 would have shown further margin expansion.
Figure 2: Group operating margin
Source: FactSet; Denker Capital estimates
Although a highly regulated industry is often considered a risky investment, in some cases, like this one, it provides a competitive advantage.
A government issued license is required to operate a legal casino and these aren’t just handed out freely to anyone who asks. To give an idea of how difficult it is to get a new casino license, Tsogo Sun, Sun International’s big land-based competitor, has been fighting for more than 10 years to move its existing license in Caledon closer to the City of Cape Town. Notwithstanding this competitive moat, it is extremely important to always be aware of the regulatory risks surrounding the industry.
Evaluating the strength of the management team is a key element of our investment process.
Despite some poor capital allocation decisions in the past, most notably the acquisition in Latin America, the new management team has done a good job controlling costs in the business, fixing the balance sheet issues, and delivering on growth targets. Recent leadership appointments at key assets, like Sun City, has resulted in a very strong turn around, while Sun Bets is the new growth engine with the right people at the wheel.
The performance of Sun City (performance history in the chart below) is a great example of the work management have put into turning around a historically (even pre-pandemic) underperforming asset. 2023 is expected to be the best year on record for the renowned resort.
The presence of strong board members ensures renewed capital allocation discipline.
Figure 3: Sun City earnings before interest and taxes (EBIT) (R’m)
Source: Company information, Denker Capital estimates.
Sun International was a late entrant into South Africa’s online gaming market but has experienced substantial growth since making it a strategic priority.
The land-based casino operators have been arguably slow to move into the online space in South Africa. Growth here has been exponential. The online market is now dominated by the likes of Betway, Lotto Star and Hollywood Bets with Sun International (SunBets) the fourth largest player.
Sun International has had an online presence since 2017 but it only became a strategic priority in 2021. Since then, the growth has been significant. They guided the market well in terms of reduced margins as they spent most of the revenue growth on customer acquisition (via marketing). This is a majority fixed cost business so there is significant opportunity for margin expansion as revenue grows. By the end of the first half of 2023, they reported an impressive EBIT margin of 29.5% – which shows how profitable the business has been this year.
Despite the aggressive growth over the last three years, Sun Bets still only has a 4% market share in the online space. The management team is targeting a 12% market share by 2026 which, if successful, would make this a R1.3 bn business. If they achieve their stated target, this will make the Sun International online business more profitable than any of their land-based casinos. In the first 18 months since communicating this strategy, they have delivered ahead of targets.
Figure 4: Sun Bet’s revenue and EBIT
Source: Company information, Denker Capital estimates.
In our view, their competitive advantage would be to leverage the strength of the Sun Brand in capturing market share in the online gaming space. While they do participate in sports betting, this is not their area of focus from a customer acquisition perspective. That space is too competitive and other players (like Multichoice as the big newcomer) probably have a competitive advantage over Sun International.
We initially invested in Sun International in early 2022 when it was trading significantly below our assessment of its intrinsic value.
The debt issues were very close to being resolved, lockdown measures were being meaningfully relaxed and gaming revenue was clearly improving (as reported by provincial gaming boards). Our investment case was therefore premised on a quick turnaround in earnings, with the share trading on a forward price earnings multiple of around 7x. This was a big discount for a highly cash generative business with growth opportunities in some segments.
As with any good investment opportunity, there are risks.
In our view, there are two important major risks for Sun International in the medium term:
1. As mentioned above, Tsogo Sun has applied to relocate its Caledon casino to Somerset West. This is important, as GrandWest Casino is currently the only casino in the greater Cape Town region. We do expect a new casino in Somerset West to have a negative impact on numbers. Hearings still need to be held on the matter before the gaming board approves this so, in our view, this is a two-year timeline in a best-case scenario for Tsogo Sun.
2. The pending Tobacco Bill banning smoking in public spaces. Smoking areas are popular in casinos and a smoking ban is expected to negatively impact footfall. There is massive pushback against this bill from various industries so it should be some time before it comes into law.
We believe the above risks are appropriately priced into the Sun International investment case. We do continue to monitor developments around these matters closely.
Despite the social concerns associated with the gambling industry, such businesses, like Sun International play a crucial role in mitigating larger social problems.
Considering the social ills that are associated with the gambling industry, a business like this is always red flagged as an ESG ‘no-no’. In our view, it is always important to consider the alternative. In the absence of large, regulated, tax paying gambling businesses like Sun International, the illegal gambling scene would thrive, which would result in an even bigger social problem. The larger leisure businesses pay significant taxes, in addition to contributing financially towards responsible gambling initiatives.
While the recovery story for this business is now complete, we think there is still growth potential.
We see growth particularly in the online business. Today the discount may not be as wide but Sun International still trades at attractive levels and management are clearly delivering on key strategic objectives. With the valuation metrics remaining attractive we continue to hold Sun International in the Denker Sanlam Collective Investments SA Equity Fund and the Denker Sanlam Collective Investments Equity Fund.
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