JSE Market Research 2nd Quarter Winner – Najja Daley from Scotia DBG

The company derives its revenues from four main business lines, namely Lottery, Gaming and Hospitality, Financial Services, and Pin Codes.

Lottery revenues are generated from sales of the company’s lottery games Cash Pot, Lotto, Lucky 5, Pick 3, Super Lotto, Dollaz, and WinQuick. For the six month period ended June 2010, the lottery segment accounted for 87% of revenues and generated $359 million in operating profits. The Cash Pot game is the major revenue earner for this segment and accounts for approximately 80% of total lottery revenues, while Pick 3 and Lotto account for 15% of sales in aggregate.

Total revenues for the lottery segment have grown at a compounded annual growth rate (CAGR) of 15.9% since 2005, amounting to $24.7 billion for the 2009 financial year.

Sales growth throughout the period has been driven by marketing, the introduction of new games, and also enhancements to existing games to increase appeal.

Income from the Gaming & Hospitality segment is attained from Video Lottery Terminal games offered at its Acropolis and Coral Cliff gaming lounges, and also from revenues derived from room, restaurant, and guest services offered at these lounges. The company has also recently released a sports betting product called JustBet.

Revenues from this segment have grown 24.2% on an annually compounded basis since 2006 and accounted for approximately 4.6% of SVL’s total revenues as at 2009. Operating profits from this segment however have been difficult to come by and as a result the company has had to close its Villagio lounge and rationalize operating hours for two of its other lounges due to faltering patronage.

The Financial Services division comprises Cambio services and remittance services offered by its MoneyGram operation which has the largest agent base in the country.

The segment accounts for less than 1% of SVL’s total revenues and has seen annually compounded growth of approximately 32% since 2005. This segment is highly dependent on the level of remittances coming into the country and tends to falter when economic forces put downward pressure on remittance inflows.

SVL earns income from the sale of pin codes for mobile phone credit through its agent network. Sales from this segment contribute the second most to revenues and have moved from $550 million in 2005 to $1.9 billion in 2009, a growth rate of 36%. Movement in this division can be attributed to the growth in the usage of mobile phone credit over the period as well as the company’s expanding agent network over the period.

The lottery products that SVL provides are discretionary in nature and as such are highly dependent on the state of the overall economy and its impact on consumer disposable income. This said, the Jamaican economy has grown at an average rate of 1% between 2000 and 2009, with growth being perpetually hindered by a confluence of factors including the exorbitantly high levels of crime and debt, and also natural disasters. The global financial crisis of 2008 has also played a role in the country’s anemic performance over the past 2 years, through its adverse impact on exports and aggregate demand.

For the period January to June 2010, the country experienced a contraction in real GDP of 1.5%. This partly reflected the effects of the unfavourable weather conditions and the protracted global downturn which continued to hurt both the goods producing and service sectors.

Inflation for the period was 6.8%, and was spurred by movements in the Food and Non-Alcoholic beverages division, increases in the price of oil, and tax increases.

The unemployment rate as at June 2010 stood at 12.4% and represents a high not seen since December 2002. The high unemployment level largely reflects the falloff in production seen for the past several quarters.

These negative indicators were all reflected in SVL’s slender revenue growth of only 1% and a decline of 2.8% from the lottery segment for the six months ended June.

Looking ahead, growth for the Jamaican economy is expected to remain sluggish, due to the absence of countercyclical policies to stimulate the economy and the recurrent weaknesses in key industries. Economic growth is projected to range between -0.5% and -1% for the calendar year, and is expected to remain suppressed going into next year. Also, agricultural supply shocks from adverse weather conditions experienced recently are expected to place upward pressure on price levels, more so on the food basket. Higher international commodity prices will add further pressure to the local food category, which could result in inflation of 9.5% for the calendar year to March 2011. These indicators suggest that SVL should continue facing growth resistance over the near term as discretionary income, which forms the basis of patronage for the company’s products and services, continues to remain weak.

Successful entry and establishment in the industry will require huge capital outlays for the large scale and wide spanning operation that would be necessary to effectively compete with the existing well entrenched industry participant. Such requirements pose a significant impediment to potential entrants.

Because of the nature of gambling, there are no direct substitutes. What could possibly be considered substitute products however may come from a sub sector of the industry such as horse racing. These sectors do not constitute real substitutes however and would not have a material influence on industry pricing.

Buyers in the industry have little bargaining power due to the lack of direct substitutes and a lack of buyer concentration.

Suppliers of inputs to the industry have low bargaining power as the large scale of the operations within the industry and the large number of suppliers of these inputs both diminish the negotiating ability of the suppliers.

Rivalry in the industry is virtually non-existent as there is only one clear market participant.

·         SVL is the sole market participant in the lottery market.

·         The company’s games have been entrenched as a part of the country’s culture and enjoy a cult following as a result.

·         It has a very well established and vast agent network through which it can effectively and efficiently penetrate most locales of the market.

·         The company’s business model, though somewhat diversified, is highly skewed towards lotteries which account for about 90% of revenues and almost all of operating profits.

·         SVL’s sales are highly cyclical and as such the company will find it difficult to grow revenues in times of economic uncertainty.

·         Given the substantial level of local market penetration that the company enjoys, expansion into regional markets would present an opportunity to diversify and grow revenues.

·         Further continuation of the weak economic conditions facing the country will pose an impediment to revenue growth for the company given the cyclical nature of its operations.

·         The company’s games are designed to have specific average payout liabilities and departures from the budgeted liabilities can result in significant bottom line impact.

·         It has been seen that the government tends to turn to ‘sin taxes’ as a way to shore up revenues when facing fiscal pressures. This could pose a direct threat to SVL and impact sales.

SVL has come under severe pressure due to the harsh economic environment in which it operates, which has led to poor results for its half year. For the six months ended June 2010, SVL reported net profit of $234 million down 30% or $100 million from the corresponding period of 2009. Influenced by depressed consumer disposable income, a continued decline in remittances, and greater than expected stability of the local dollar, the company has seen a slowdown in growth of most of its business lines, as revenues rose only marginally by 1% to $12.5 billion for the period. The Pin Code segment was the only division recording any significant growth, with a 26% increase in revenues to $945 million, while the Lottery segment posted flat revenues of $10.9 billion, as the Super Lotto continued to perform far below company expectations. The Gaming & Hospitality and Financial Services segments posted 9.5% and 15% declines respectively to $522 million and $74 million.

Cost of sales increased 1.4% to $11 billion from $10.9 billion, and resulted in gross profits of $1.45 billion. Total operating expenses increased 16% to $1.1 billion from $975 million, and were driven by costs incurred in the start up of Acropolis Portmore and also the roll out of its new sports betting venture, JustBet. Resulting operating profits experienced a 36% decline to $322 million from $504 million.

Interest income rose 33% to $45 million while FX gains and finance costs both declined by 68% and 37% respectively to $6.7 million and $9.1 million. SVL’s resulting net profit attributable to shareholders registered a decline of 30% for the period to $234 million, with EPS moving from 12.66¢ to 8.86¢.

As at June 2010, SVL’s total assets stood at $4.7 billion, 8.7% more than the $4.3 billion reported in June 2009. The company’s long term debt fell 75% to $52 million from the $210 million as at June 2009. Shareholder’s equity increased 10% to $3.3 billion.

SVL’s return on equity has averaged just above 20% for the past five financial years. The profitability measure has consistently been driven by asset turnover; which is typical for companies in this sector. This effective utilization of assets, rather than a reliance on leverage, speaks to the fact that gains could be derived from altering their capital structure by slightly increasing debt.

The challenges currently being faced by the company are expected to continue for the remainder of the financial year and going into the new year, with the Lottery and Gaming & Hospitality segments expected to suffer the most, as these are the business lines that are tied most closely to consumer disposable income. Though new games have been introduced and existing games, such as and Pick 3, have been modified to stimulate sales, the group has yet to find success in countering the downward trend that revenues are currently undergoing. With unemployment at historically high levels and not expected to improve much for the near term, it is expected that SVL will find it extremely difficult to deliver improved bottom line performance for shareholders.

SVL is expected to complete the next twelve month period with results that reflect the harsh macroeconomic environment. In the context of a projected decline in GDP, we expect to see lottery sales faltering as consumers grapple with the diminishing real values of their dollars, and cope with allocating those dollars to increasingly costly staples. The company’s other segments, which contribute slightly to revenues and significantly less so to profit, are also expected to come under pressure as both a sluggish US economy and a tepid FX market take a toll on remittance and cambio profits respectively. With the bleak economic outlook and its expected impact on revenue growth, SVL will have to place some focus on cost cutting in the near to medium term to mitigate the falling sales.

This given, revenues for the twelve months to end June 2011 are expected to register a 2.5% decline to $27.6 billion. Margins are projected to come under some pressure as products such as the Super Lotto, JustBet and the newly opened lounge in Portmore struggle to gain traction while demanding significant marketing and other resources. As such, net profit for the period should approximate $580 million or an EPS of 22 cents.

To arrive at a valuation for SVL a P/E model and a Free Cash Flow to Equity (FCFE) model were utilized. More than one model was used in order to ascertain a more robust estimate of company value. The price multiples method was used due to the fact that SVL has traded in a particular band in recent history that has been close to its intrinsic P/E. The FCFE model was used because the company has been free cash flow positive and these cash flows have related directly to the company’s profitability.

In ascertaining a justified P/E[1], a dividend payout ratio of 70%, which is in line with the historical average, was used. The cost of equity of 16.1% was calculated using the capital asset pricing model – with beta, risk free rate, and equity risk premium estimates of 1, 12.5% and 3.61% respectively. The beta used was the five year monthly beta for the stock relative to the JSE Market Index. The long term growth rate used was 8% and was assumed from long term economic growth forecasts in conjunction with company specific factors such as business cycle stage and industry profitability prospects. Inputting these assumptions into the model yields a P/E ratio of 8.65X. This compares to a current P/E of 10X and a historical average of about 8.5X. Applying this P/E to our EPS estimate gives a price of $1.90.

A two stage FCFE model which uses the same inputs as highlighted above yields a price per share estimate of $2.46.

The two methods suggest a price trading range of between $1.90 and $2.46, or an average price of $2.18. Given the current price of $2.17, a HOLD is recommended for SVL stock at this time.

Technical analysis is also supportive of this view, with a RSI of 49.11 (as shown below) the stock is trading within the neutral zone and may be viewed as appropriately valued.

Ø Slowdown in US economy and further protracted local economic deterioration will adversely affect revenues.

Ø High volatility in the Cash Pot liability could cause severe swings in direct expenses versus budget.

Ø Continued lack of interest in Super Lotto and JustBet products will impact negatively on margins.

Bloomberg L.P

Supreme Ventures Limited Annual Report

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