I am increasingly concerned about the outlook for the East Coast Australian consumer and today I’ll explain why that has made me change my view on Star Group from positive to negative.

At the macroeconomic level, it should be clear to everyone now that mortgage interest rates have bottomed. The major Australian banks have increased mortgage rates out-of-cycle, exercising their impressive oligopoly pricing power. They have also started weaning investors off interest only loans and decreasing LVRs.

The Reserve Bank of Australia also joined the global central bank “hawk” trend this week, reminding everyone that interest rates can and will rise from these levels.

Quite simply, this means debt servicing obligations are rising for Australian households, who have never been more indebted. With record low interest rates and record amounts of debt, even small rises in mortgage rates have a large effect on household cash flows. This is particularly so in a period of sustained low wage inflation and cost of living rises.

The cash flow squeeze has started on Australian households and the main negative effect will be on all forms of consumer discretionary spending. This includes gaming and wagering, which will not prove “defensive”. This trend has already started with Victorian poker machine revenue data showing negative growth. I believe that will spread and that is why I am changing my view on Star Group (SGR) from positive to negative, feeling the upcoming FY17 result and forward guidance will be weak.

Star has embarked on a major multi-year capex spending programme in Sydney, Brisbane and the Gold Coast. With the structural changes to inbound Chinese VIP gaming tourists since mid-last year, I believe this huge ($4b) capex spend now looks ambitious for the end market it is going to service. These assets will be dominated by domestic visitors, and you only have to look over at Crown Towers Perth to see an asset that was designed for Chinese high rollers but, in reality, today frequented by Perth locals.

Timing is everything in large capex spending, if you want a quick payback on your capex. I now worry SGR is building a series of major assets that have missed the moment in terms of peak foreign tourist demand for them.

My concerns are that the occupancy rates, average room rate and ancillary spending forecasts underpinning these projects will prove too optimistic, just as the Crown Towers Perth example seems to confirm. I’m also concerned around forecasts for apartment sales and prices in these projects.

Because there is up to a five-year lag between the board decision to expand and completing, the risk of misjudgement is large. A lot can change in five years, but once your project is coming out of the ground, there’s no turning back. This is basically committed capex but my view is the outlook is changing rapidly and the returns generated by these projects will be significantly lower than expected and debt taken on to fund them will take significantly longer than forecasted to repay. This will be occurring in a rising interest rate environment.

I’m sure I am not alone in these concerns and history suggests companies, in a sector, embarking on very large capex spending programmes tend to underperform because investors and analysts become worried about the returns, or not, that capex will ever generate. Avoiding the “building” phase as such is generally a good plan and another reason I am now negative on SGR.

In terms of short-term earnings, you can see SGR is now seeing consensus earnings downgrades. The chart below confirms FY17 estimates for SGR have been falling and how correlated SGR has been to those consensus earnings estimates through time.

The chart above tells you the last time that SGR FY17 estimates were here, the stock was trading at $4.50, and that’s around the downside share price risk I see in SGR shares from these levels.

Interestingly for the FY18 year we are about to enter, the year I am concerned about on multiple fronts, SGR EPS estimates have fallen from 33.5c to 29.4c. I think that 29.4c will prove too ambitious and believe SGR’s EPS will be flat to down in FY18 implying -10% EPS downgrades at the consensus level for the year ahead. If that’s right, that would most likely take -10% or more from the SGR share price.

SGR currently trades on 18x FY18 consensus earnings, earnings I think are most likely -10% too high. If my forecasts prove more accurate, SGR is trading on 20x realistic FY18 earnings, which is too high for a stock with no growth, a very big capex spend, and no corporate appeal.

Crown Resorts (CWN) and Genting have both sold out of SGR. To me, that is confirmation that SGR now has no corporate appeal and the P/E should fall to reflect that.

While others dream up CWN/SGR merger ideas, there’s zero likelihood of that in my view for both fundamental and regulatory reasons.

The largest investor in SGR is now Perpetual at 14.7% and obviously they can’t take over SGR.

In previous times, SGR has commanded a premium for corporate appeal that I think is now completely unwarranted.

Post the recent Genting sell-down, the domestic institutional market now has the “house full” sign up in terms of ownership of the stock. I struggle to identify the next marginal buyer of a stock that is now domestically over-owned and potential cum a weak result and weak forward guidance.

The last time SGR made a presentation to the market was back in May, which guided to +4.1% gross revenue improvement in the period 1 January to 30 April. This was despite “softer” gaming market and “macroeconomic conditions”. They also stated that “management continues to optimise its domestic and international cost base to reflect trading conditions”.

I am concerned that headwinds have accelerated since that point in early May and SGR wouldn’t have been able to cut costs fast enough to offset revenue weakness. I guess we will find out soon enough at the full year result in August.

It’s worth noting the FY17 interim result back in February was weaker than expected and the stock traded down around $4.60. I don’t think much has improved since then but a rising SGR share price gave a corporate an opportunity to sell out.

The AIM global high conviction fund has changed its view on SGR to negative and exited our investment. We are considering shorting the stock ahead of the FY17 result and commentary, feeling there’s far greater, value, growth and upside to be found in our high conviction long investments in Wynn Macau and Galaxy in Hong Kong. Macau gross gaming revenues are growing +25% and we would rather invest with that tailwind than fight headwinds on the East Coast of Australia.

As Kenny Rogers sang in “The Gambler”: “you’ve gotta know when to fold ‘em”. I think it’s time to “fold ‘em” in Star Group (SGR) for the multitude of reasons I identify above.

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