Fitch Ratings has affirmed Japan-based Universal Entertainment Corporation's (UE) Long-Term Issuer Default Rating (IDR) at 'B-' with a Stable Outlook.

The agency has also affirmed UE's outstanding US dollar senior secured notes at 'B-' with a Recovery Rating of 'RR4'.

The affirmation and Stable Outlook reflect UE's strong revenue and EBIT recovery to pre-Covid-19 pandemic levels. We expect UE to continue to generate strong free cash flow (FCF) as operations stabilise, leading to a steady reduction in leverage. However, UE's weak financial flexibility, including a concentrated maturity profile, offsets the benefits of the positive developments.

Key Rating Drivers

Continued Integrated Resort Growth: We expect integrated resort (IR) revenue to rise by 40% in 2023, to be followed by more modest growth of around 20% in 2024 and 2025. The growth rates are faster than our assumptions for comparable global casino markets because UE's Manila IR facilities only became fully operational in December 2021. In addition, UE has never received a significant volume of international travellers due to the pandemic, with domestic customers driving the recent recovery.

UE's IR revenue in 2022 exceeded the pre-pandemic peak in 2019, but the number of casino visitors in 2022 was still lower than in 2019. We expect the total number of visitors in 2023 to recover to at least 2019 levels, with increased spending per visitor, leading to the robust growth in 2023.

Mature Amusement Equipment Segment: The amusement equipment segment faces uncertain end-market demand and has previously exhibited volatile performance. However, the segment is financially self-sufficient and has paid for the construction and financing needs of the IR business. We forecast segment revenue to rise by 16% in 2023, assuming a continued recovery in sales volume and average selling prices. However, flat sales volume and only a slight increase in average selling prices is likely to result in modest growth of 3% in 2024 and 2025.

Continued FCF Generation: We forecast that UE will maintain its FCF margin at 10%-11% through to 2025, given a lack of significant capex and investment requirements. UE's capex has dropped with the completion of the IR construction. This, together with the steady recovery and growth of its revenue and EBIT, has led to robust FCF generation. UE reported a FCF margin of 11.7% in 2022.

Improving Leverage: UE's leverage is strong for its rating. Higher EBITDAR and cash have reduced its EBITDAR gross and net leverage, while debt remains broadly unchanged. EBITDAR gross and net leverage were 4x and 3x, respectively, at end-2022. Our rating-case forecast points to cash accumulation and continued leverage reduction, which will further improve UE's leverage metrics.

Maturity Concentration: Secured notes totalling USD784 million (JPY105 billion at end-2022) mature on 11 December 2024. The notes accounted for 90% of UE's total debt as of end-2022, presenting significant refinancing risk. We expect UE to generate JPY41 billion in FCF in 2023 and 2024, which indicates a need to refinance all or part of the notes. Failure to address the maturity issue in the next 12 months could lead to a downgrade.

In addition, UE has various legal disputes that could damage investor and lender confidence in its corporate governance and weaken the company's ability to source funding. The negative impact of UE's governance issues is reflected in its rating and EGS Relevance Score of '4' for governance structure. We will review UE's ratings if we observe a significant deterioration in its governance structure.

Small Size, Weak Market Position: UE has continued to improve its financial profile, but its business profile remains weak relative to global gaming peers. UE's small size, single-asset IR operation and niche amusement equipment manufacturing, among other factors, have led to our assessment of UE's weak business profile, which is consistent with UE's rating.

ESG - Governance Structure: UE has concentrated ownership by the founding family and a dispute with its founder and former chairman. This has a negative impact on the credit profile and is relevant to the rating in conjunction with other factors.

Derivation Summary

UE operates the largest casino in Manila's Entertainment City, but this is its only IR asset. The IR is small compared with most rated peers.

US regional gaming operator, Bally's Corporation (B+/Negative), is comparable with UE in terms of revenue and profitability. Bally's owns and operates 14 properties in 10 US states, which supports better operational stability compared with UE.

Macau-based gaming operator, SJM Holdings Limited (SJMH, BB-/Negative), and UE are similarly geographically concentrated, although SJMH is much larger than UE.

Key Assumptions

Fitch's Key Assumptions Within Our Rating Case for the Issuer

Revenue growth of 28% in 2023 and 13% in 2024

EBITDA margin to remain at around 22% in 2023 and 2024

Total capex of JPY9 billion in 2023 and 2024 each

No dividends or share buy-backs in 2023 and 2025

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

Sustained FCF generation;

Better maturity-profile spread.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

Lack of clarity of the refinancing plan by end-2023.

Best/Worst Case Rating Scenario

International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

Liquidity and Debt Structure

Concentrated Maturity: UE's debt maturity schedule is highly concentrated in 2024, with a significant reliance on US dollar-denominated bonds for funding.

Readily Available Cash: The company says that it requires a minimum cash balance of JPY7 billion, including a guarantee deposit, for its IR operation under local gaming regulations, which is not readily available for debt repayment. The funds are also required for potential working capital fluctuations in its amusement equipment segment. We have therefore classified this amount as restricted cash.

Issuer Profile

UE is a Japanese gaming equipment manufacturer. It operates two key segments: the amusement equipment segment, which includes the development, manufacture and sale of pachislot and pachinko machines in Japan, and the IR segment, which focuses on the operation of Manila Okada, an integrated casino resort in the Philippines.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

UE has an ESG Relevance Score of '4' for Governance Structure due to the concentrated ownership by the founding family and a dispute with its founder and former chairman. This has a negative impact on the credit profile and is relevant to the rating in conjunction with other factors.

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg

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