Shareholders of casino operator Echo Entertainment Group Ltd (ASX: EGP) have finally been rewarded in 2015. Following excellent half-year results, the share price has increased by over 40% and easily outperformed the broader market.
With the market still nervous about its major rival Crown Resorts Ltd (ASX: CWN), could Echo be the better long-term investment?
In my opinion, I don't think so, and here is my reasoning:
- Echo's return on equity is less than 5%. To put this in perspective, Echo creates less than $5 of profit for every $100 of shareholders funds. Many investors would be able to create a better return without the risks involved in operating a business. To be considered an efficient business, investors should expect a return on equity of at least 10%.
- Echo does not have any significant offshore exposure. The biggest growth opportunities available to casino operators at the moment are in developing countries. While there is no doubt the risks involved in operating casinos abroad will be more challenging, the potential returns are also greater.
- Echo will face more competition in the domestic market. The impacts of the new Crown Sydney development are still unknown and this could especially hurt Echo's growing VIP business. If Echo's bid for the Queen's Wharf project in Brisbane is unsuccessful, this could also significantly impact its future operations. Not only will Echo have missed a significant growth opportunity but it will also introduce a new competitor into the Queensland market.
- The casino operator faces ongoing significant capital expenditure. In order for Echo's properties to remain attractive to consumers, a high level of capital expenditure is required. In FY15, capital expenditure is expected to be between $200-$250 million as the company upgrades and expands its casinos in Sydney and the Gold Coast. Although Echo has seen improved results from its investment program in Sydney, extensive work still remains in its Gold Coast property to restore its competitiveness within the region.
- Although the company increased normalised profits by more than 77% in the first half, it is unlikely it will be able to replicate this result again. Echo produced this result off a very low base and was driven primarily by an irregular doubling of revenue from the VIP business.
Foolish takeaway
At the current share price, Echo is being valued at around 20x forecast FY15 earnings. The high valuation implies that strong earnings growth has already been priced in and the upside potential will be limited. Investors should be aware if management does not deliver strong earnings growth for the full year, the share price may come under pressure.
For a long-term investment in the entertainment sector, I still consider Crown Resorts as the premier investment and I would suggest investors take a look at its long-term potential before investing in Echo Entertainment.
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