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No ave for EVA from Sky City duo

By Shoeshine

Friday 31st October 2003

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Would you buy a convertible note now for $1.56 if you knew it would convert in three years to two ordinary shares worth $1.14 each?

Does Dolly Parton sleep on her back? That's an annual return of 14% ­ and no tax.

That's the happy prospect for anyone who can get hold of some Sky City Leisure (formerly Force Corporation) mandatory convertible notes at the last traded price.

Not that it will be easy. With Sky City Entertainment sitting on all but 7.2 million of the notes, there aren't a lot to trade and the rest of the holders are probably content to sit on them.

The notes, flogged off in a December 2001 rights issue for $1 each, convert one-for-two into Sky Leisure shares in December 2006.

Sky Entertainment took up all its 50.2% entitlement and underwrote the rest of the issue, ending up with 77% of them.

Those who didn't stump up for the rights issue will be kicking themselves. Since then, although Sky Leisure's circumstances have improved considerably, the head shares have trailed sideways. Over the same period the notes have bounced around like a kangaroo on coke, reaching $2.10 on a couple of occasions.

Both securities' performance seems at first glance illogical but there's method in the market's apparent madness.

At $1.14 Sky Leisure's ordinary equity is worth a puny $7 million. As it has a $12.5 million deficit of shareholders' funds, even that would ordinarily look heavily overpriced.

Adding the $48 million market value of the notes gives a market capitalisation for the company's "equity and capital funds" of $52 million and an enterprise value of $112 million.

The 14% annual return on the notes assumes the share price won't be below its current level in three years' time. That's not a bad bet but it's not without risk.

Sky Leisure's $3.3 million June-year profit, while a heck of a lot better than the previous year's $20.1 million loss, is still a long way short of its cost of capital, which PricewaterhouseCoopers calculates to be 11.5%.

Curiously its chairman, David Gascoigne, was unable when asked last week to disclose any plan to close the gap. Evan Davies, Sky Entertainment's managing director, had nothing to say on the subject.

Their responses suggest they think bottom line profit is what counts and economic value creation is a mere accounting abstraction, rather than the other way round.

So investors will have to go on what Gascoigne said in the annual report and at the annual meeting.

Sky Leisure, according to Gascoigne, is "poised for a further year of strong earnings growth," having freed itself of "balance sheet distractions."

It will do this by focusing on efficient operations and an "integrated marketing approach." The key growth strategy seems to be to "seek market share growth" through projects such as the multiplex at Auckland's St Lukes, opened in May, and a planned eight-screen cinema in Tauranga.

The capital costs involved are not huge and provided the company can fill its cinemas Gascoigne should be able to produce his earnings growth this year.

But the company is by no means out of the woods yet. With $60.5 million of term debt it's heavily geared. Its ebitda (earnings before interest, tax, depreciation and amortisation) cover is a skinny 2.2 times compared, for instance, with Sky Entertainment's 5.6 times.

Those earnings are at the mercy of Hollywood. Last year Tinseltown produced a string of crowd-pullers. This year the third part of The Lord of the Rings is bound to pack them in but the film industry has had duff years before and will no doubt have them again.

Sky Leisure's plan is no doubt to use earnings to whittle away at debt but it will take some years to get back into the comfort zone.

Even when or if it gets there it won't necessarily be returning its cost of capital.

Sky Entertainment's Davies rightly basks in the market's approval of his company's outstanding wealth creation record.

But Shoeshine has yet to meet anyone who understands the foray into the up-and-down cinema business.

If there's a cunning plan, let's hear it. That might even shake Sky Leisure's share price out of its slumber.

Having put two resolutions on the agenda for last week's annual meeting of Trans Tasman Properties, it seemed strange dissident shareholder John Powell declined an invitation to speak in support of them.

Queried after the meeting, Powell said there was no point ­ chairman Don Fletcher was wielding the proxies of 55% shareholder SEA Holdings, which had already declared itself against Powell's proposal to wind up takeover target Australian Growth Properties and distribute the cash. Which makes you wonder why he put them up for voting in the first place.

Also, he said, he didn't want to compromise the oppression action he was pursuing against Trans Tasman Properties' majority shareholder, SEA.

This was thrown out on Wednesday by High Court Justice Hugh Williams. It hardly counted for Powell that the paper profit he is sitting on ­ $5.2 million, or 118% in two years ­ is greater than the benefit he would have got from a court order that SEA buy him out at his estimated 55c net asset value.

Powell's voting behaviour was no more cogent than his lawsuit.

Chairman Fletcher explained at the outset that shareholders could vote for the Australian Growth Properties takeover or for Powell's distribution proposal ­ but not for both.

That's because under Australian takeover rules the bidder's statement for a company making a takeover offer must state its intention. Trans Tasman Properties has said it would run Australian Growth Properties as a going concern. If it turned around and wound Australian Growth Properties up it would be in breach of Australian law.

The outcome of voting shows Powell nonetheless voted his 17.4 million shares in favour of all three resolutions.

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