I've learned the hard way that one of the most important questions to ask before investing in a company is to ask 'what if?'
The question is broad, but it makes you think about all the things that could go wrong, even if there is only a small chance that they will. As Howard Marks says: "Likely events sometimes fail to occur, and unlikely events sometimes do."
Like when Star Entertainment Group Ltd (ASX: SGR) lost tens-of-millions of dollars to high rolling VIPs playing baccarat. The odds may have been low, but it was a very real probability which came through.
And at $5.82 per share, 'what if?' seems like a good question to ask of Star Entertainment Group Ltd (ASX: SGR) right now. Shares have more than doubled in the last two years and the company's Enterprise Value-to-EBITDA (Earnings Before Interest, Tax, Depreciation and Amortization) ratio of 14 sits at a premium to Crown Resorts Ltd (ASX: CWN) and SKYCITY Entertainment Group Limited-Ord (ASX: SKC) at 13 and 10 respectively.
The price of growth
The premium assigned to Star can be attributed to the big growth prospects investors see in the company. Expanding the Jupiters casino on the Gold Coast and a 50% share in building an iconic resort on Brisbane's Queen's Wharf are great reasons to be excited about future prospects.
This significant growth will require significant capital expenditure. Star anticipates expenditure of $1 billion alone for its share of the game changing Queen's Wharf Brisbane and greenfield projects generally come with more risk than expanding existing operations.
Growing VIP exposure
Another concern though is the extrapolation of current "International Business" demand. This is also referred to as VIP, high-roller or junket business.
According to the Star's half-year presentation "normalised" (average) International VIP business represented 27% of total gross gaming revenues. This was similar for Crown Resorts (28%), and less for SkyCity (17%) over the same period.
But compare this to two years ago where Star was 21%, Crown was 22% and SkyCity was just 7.5%. While it's possible the companies have just become very good at marketing to and catering for these VIPs, the increase also co-insides with the huge downturn in Macau gaming revenues.
Making capital expenditure decisions by extrapolating recent trends can be a complete disaster for investors. The massive capital expenditures by energy companies into LNG five years ago while the price of oil was high is an example. The numbers make sense during boom times, but what happens if demand drops, or supply surges?
In the case of Star Entertainment, what happens if junket business stops like it did in Macau? If local governments start regulating the VIPs, or Macau somehow surges back to life creating competition for the big spenders. The odds of each may be low, but sometimes unlikely events do occur.
Foolish takeaway:
Star Entertainment has a strong long-term growth outlook with several exciting projects. However in my view the company's current valuation already reflects the optimism; pricing in a lot of greed and not enough fear.
Of course the company may continue to perform well in years to come, but before parting with your hard earned cash, be sure to ask yourself 'what if?'
