Federal Hotels: the turning point?

It is difficult to escape the conclusion Federal Hotels’ problems are largely of its own making as a consequence of the path chosen, the capital structure and dividend policy pursued.

The closure of the West Coast Wilderness Railway will have a devastating effect on West Coast tourism operators, none more so than Federal Hotel’s own Strahan Village business.

At first glance it may appear as if Federal Hotels is shooting itself in the foot. More realistically it has positioned itself  in the middle of a poker game, hoping to win a few chips brought to the table by other players, knowing full well the railway will never ever close.

The timing of the lease forfeiture to coincide with Wrest Point's 40th anniversary celebration of its contribution to  Tasmanian tourism industry is almost enough to stir feelings of cynicism  among even the most forgiving.

In order to fund its way any business needs to generate cash operating surpluses or rely on the  cooperation of lenders ( and/or shareholders but in Federals' case this source does not provide further funds).

The following table shows the operating surpluses plus new borrowings available to Federal Hotels to pay investing and financing amounts, the amounts required to keep banks and shareholders happy and to keep spending on new capital to ensure growth and future income.
                                                            CASH IN ($ M)

 

                                                  

The most obvious features of the above table are:

·       operating surpluses are flat lining in nominal terms (declining in real terms), and

·       borrowings were nil in the latest year.

Lenders have reassessed their exposures to poker machine companies. See for example early rumblings HERE

Operating cash has been a little languid and borrowings have increased by $101 million or 74% over a 6 year period to help fund the investing and financing needs of Federal Hotels.

Included in ‘financing’ are the lease payments for poker machines used in its own gambling parlours, as well as hired to hotels and clubs to ply their trade under license.

The following table shows the level of borrowings growing over time in a  pattern similar to many companies  in boom pre GFC days.

                                       BORROWINGS OUTSTANDING ($ M)


 

The breakup of investing outlays (new assets and business takeovers) and financing outlays (finance costs and dividends to shareholders) is best captured in the following table. The problems confronting Federal Hotels leading to its planned divestment of responsibility for the West Coast Wilderness Railway are readily apparent. 



                             CASH OUT: INVESTING & FINANCING ($ M)



 New asset and capital improvements are shown in ‘green’. The construction of the unprofitable Saffire as mandated by the 2003 agreement with the Government, which would have to rank amongst the dumbest public policy decisions ever, is noticeable in 2009 and 2010. The reputed cost was $32 million.

Outlays to purchase existing businesses are shown in ‘purple’ with major purchases in 2007, 2009 and 2011. It is likely that subsequent capital improvement  to these properties, particularly Freycinet and Cradle Mountain are included in 'green'.

Whilst the Freycinet and Cradle Mountain purchases in 2009 can reasonably be seen as forming part of a tourism strategy, as explained to the people of Tasmania in 2003 (see transcript of 2003 Parliamentary Public Accounts Committee Hearings HERE ), the purchase of the 9/11 chain of bottleshops and the two pokie pubs from the Goodstone Group in 2011, hardly fit that same strategy.

Then there are the unrelenting demands of shareholders, with dividends of between $15 and $18 million paid each year. Based on balance sheet values that equates to a 10% fully franked return.

The past year 2012, with no additional borrowings meant less was available to spend on investing and financing. Dividends (blue) continued and finance outlays(red) increased, not only due to the increased borrowings requiring more interest but also because the banks needed a $9 million reduction in loans outstanding, no doubt due to increased nervousness in the industry.

Hence there was not much left to spend on new assets (green), only about $5 million. The 2012 situation encapsulates the dangers lurking ahead for Federal Hotels. It confirms that draining retained earnings to pay dividends as shown HERE is putting pressure on cash flow. 

Federal Hotels is quite a simple business from an overall cash flow view point. Cash inwards each year is roughly similar to cash out.

A business with $384 million worth of tourism property and plant assets on its books needs to spend much more than 1.3% on capital improvements to stay ahead of the pack. It is a serious problem.

The split up of gambling winnings between Federal Hotels, Government and pubs and clubs in 2012 is little different to that in 2010 and 2011, at about 70%, 23% and 7% respectively. Gambling represents almost 50% of turnover for Federals' and almost certainly a much higher % of net operating surplus and net profit.

The issue for policy makers is not whether shareholders pay themselves too much, for they are free to choose.

The issue is whether the granting of an exclusive license at below market rates to a large player in the industry in the hope that the benefits will percolate through the tourism industry rather than diverted elsewhere is optimum public policy.

At the time this wasn’t of concern to Treasurer David Crean whose commendable faith in humanity unpinned and committed the State to a  15+ year  agreement with Federal Hotels when he observed...”let us face it with that family that is unlikely to be a problem because they are a terrific operator”.

The Deed setting out the 2003 agreement between Federal Hotels and the State in Schedule 1 of the Gaming Control Act 1993 HERE appears to contain in Clause 3.3 provision to increase the Government’s take from poker machine. Four years notice needs to be given prior to June 2014.

Where is the public policy discussion?

Tax on pokies will increase from 1^st July in line with the 2003 agreement. Not before time as Federal Hotels have received a 10 year bonanza being exempt from the 4% Community Service Levy which applied to pokies in pubs and clubs but not Federal’s two casinos.

Sidestepping the morality and inequity of pokie tax, why not claw a bit more from Federal Hotels without affecting players’ returns, to pay for tourism marketing (which the Opposition has promised) or the railway upgrades (which everyone is demanding).

Maybe go a step further and get Federal Hotels to put its exclusive 2003 agreement on the table, start again and chart a funding plan for the industry for the next 10 to 15 years, a funding plan that will provide more certainty and remove the tourism industry from its incessant begging for more funds, whenever there’s a Budget, whenever there’s an election, whenever there’s a downturn, whenever they need a new marketing campaign, whenever they need more funds for infrastructure, whenever they can’t maintain an asset leased from Government, whenever ........... whenever they see a chance to freeload?

How about a plan that’s not a backroom deal providing windfall gains to one entity hoping it’ll do the right thing over the term of the agreement?

Such a reorganisation might well allow Federal Hotels to reorganise itself. Family companies inevitably run into problems with conflicting goals and aspirations amongst second and third generations not being adequately catered for within a monolithic structure and the ensuing difficulties facing shareholders who wish to exit. Its structure may not be suitable to handle another generation. It’s obviously in need of a serious check-up.

It’s not just a question of maintenance costs on the West Coast Wilderness Railway, serious as they may be.

Can Tasmania rise to the occasion?