BEFORE WE START, WHAT KIND OF INVESTOR ARE YOU?

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    26 March 2021

    Following the damning findings from the Bergin Report into Crown Resorts, the company has been given the opportunity to rectify its governance issues.

    Governance issues at the forefront

    Crown Resorts Limited started its listed life in 2007, having been spun off from its parent company PBL. With its history (and share registry) tied to majority shareholder James Packer, Crown’s corporate governance has always been a sticking point for the Nikko AM Australian equity team. As part of our investment process, we have always factored in corporate governance risk, with our valuation incorporating a 5% ESG discount back in 2015. At the time, this equated to a $500m hit to the valuation. Many years before the arrests of Crown employees in China, we had identified a number of the issues that have been highlighted at the Independent Liquor and Gaming Authority (ILGA) enquiry. The chief issue is the undue influence a majority shareholder was having on the board, creating poor corporate governance, which ultimately led to strategic decisions made to the disadvantage of minority shareholders. This was evident by related party transactions that involved RatPac, Studio City, Ellerston, and Nobu. As a result of our concerns around corporate governance, we were unwilling to pay a premium for these assets and thus never owned Crown until late 2020.

    Quantifying ESG risk

    Ultimately, investing is all about risk and probabilities, and what is priced in for that risk. In our view, Crown’s share price went from completely ignoring, to overly discounting, ESG risk and the likely outcome from the ILGA inquiry. Therefore, we believe Crown to be cheap relative to its peers, and very cheap relative to the market.

    From an earnings perspective, we assumed that VIP revenue would be down 60% from previous peaks. This essentially assumes that Crown no longer uses junkets for its VIP business, with minimal offsets i.e. Crown cannot convert the junket players into direct VIP players. While the company does not disclose VIP earnings, we estimate this could be a AUD35m impact to earnings relative to previous peaks.

    This assumption has not changed following the release of the Bergin report findings. We originally assumed an AUD10m step up in compliance costs, which is another AUD100m impact to the valuation. After the release of the report, we increased compliance costs by an additional AUD35m, capitalizing a AUD45m step up in compliance costs.

    We assumed a AUD300m fine from AUSTRAC that is based on comparing Crown’s Anti-Money Laundering (AML) breaches against Westpac, CBA, and Tabcorp’s breaches and fines.

    Finally, we continue to apply a 5% governance discount to our valuation. The total valuation impact for all our ESG adjustments is AUD1.3b. Despite this ESG discount to our valuation, CWN traded at a discount to both Star Entertainment (SGR) and SkyCity Entertainment (SKC) on a normalised, sustainable earnings basis, despite in our view having superior quality hard assets.

    Down, but not out

    Our positive view on the quality of these hard assets and monopoly licenses has been supported by the recently announced take-over proposal by Blackstone Group (on 22 March 2021). While competitors Star and SkyCity would be a much simpler acquisition (i.e. less regulatory risk), the bid for Crown highlights the quality hard assets that Crown has accumulated over the last 2 decades. While the offer is highly opportunistic, it highlights the fact that should the listed market not correctly price these assets, then there is a strong chance that the unlisted market will. Globally, the break-up of casino assets into operating assets and property assets to unlock value has been an emerging trend that has yet to reach our shores.

    Prior to the release of the Bergin Report in February 2021, our expectations were that Crown would not lose its operating licence but rather would be given the chance to rectify all the corporate governance issues and the AML procedures. This conclusion was based on the VIP Management Agreement between ILGA and Crown, the terms of reference given to Commissioner Bergin from ILGA, our engagement with ex-regulatory executives and external lawyers, our engagement with the company, and from Crown’s AGM presentation highlighting the reforms to be enacted by Crown ahead of the release of the Commissioner’s report. Should Crown be given the opportunity to rectify its issues (which appears highly likely), then in our view there is considerable value in the stock at the purchased price levels. Part of the journey to rectify these issues is the refreshment of the board to represent minority shareholder interests. This is something we have and are actively engaging with the company.

    The findings from the Bergin Report were a damning indictment on certain members of the board and executive team. That said, the findings were not materially different from our expectations, and what we had factored into our base valuation, and investment case. It appears that VIP junkets will be banned, an independent gaming regulator will be established (to be funded by the operators), AML procedures will be tightened/automated, transactions above $10k will be more closely scrutinised and sweeping changes will be made at the board and executive levels.

    Can change occur?

    When looking at companies that are discounted for poor management or other ESG issues, an important aspect we ask ourselves is—can change occur? Do we as an investor have the ability to be involved as a change agent? The Columbia Business School has many case studies that look at this issue and show companies that have a large dominant shareholder find it difficult to implement change successfully. Crown certainly looked like that for many years. However, our recent entry into the stock was based on a strong view that the transformational governance change that was coming at Crown would eventually result in a positive re-rating of the stock. We have had numerous meetings with the company and have prosecuted and encouraged the transformational journey.

    Conclusion

    In summary, ESG has always been an extremely important input into our valuation, and our investment decision-making process. That said, we strongly believe ESG issues can be both a cost/risk, as well as an opportunity. In the case of Crown, the current ESG issues are more than reflected in the current share price. Value can be realised for investors who have a longer-term investment timeframe, in addition to being willing to actively engage with the board to improve governance issues. This is something that we are willing to invest our time and efforts into, to unlock value for our investors. While the takeover offer from Blackstone has helped to accelerate the value realisation, it is also positive in that it highlights the fact that investment opportunities can be found when approaching ESG issues with a robust framework.

    26 March 2021

    James Nguyen

    Portfolio Manager and Senior Research Analyst, Equities
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