Macau's Lessons

Trees don't grow to the sky, so investors should not be surprised

Macau’s Lessons

Warren Buffet has famously said his favorite stocks are those of companies so well-managed and with such competitive moats that you can go away for years, return and your investment would be more valuable and intact.

For years, that was the degree of confidence investors appeared to have in Macau casino operators.

They were helped along by analysts who did straight-line projections of Chinese growth, calculated low market penetration and forecast double-digit growth to the horizon and beyond.

I have used this space several times during that period to warn against overexuberance.

There were three reasons:

• Trees do not grow to the sky, to use an old Wall Street expression.

• The Chinese government is still run by the Communist Party, so businesses, by definition, live in jeopardy of government policy. That is especially true of gambling companies.

• Success breeds competition.

So, here we are with investor confidence badly damaged, if not shattered, as government policies—tighter credit, a smoking ban and really, truly, this time, a crackdown on corruption—have slammed gaming revenues.

Meanwhile, off in the periphery, the Philippines is building mega-resorts and NagaCorp in Cambodia is drawing Chinese players, many brought by Macau junketeers who are finding business tougher at home. And Korea, Vietnam, Australia and maybe Japan could join in.

Further, the recently held tenet that the six mega-resorts rising in the Cotai section of Macau would ignite huge growth has transformed into a worry about excess capacity in the face of declining revenues.

Even the much-heralded growth of the mass market, thanks to the burgeoning Chinese middle class, is getting hit.

Analyst Phoebe Tse of Barclays noted that the smoking ban on the main casino floors has resulted in a migration of high-end players to the VIP rooms where smoking is permitted, but where casino profit margins are lower.

Mass table game revenue fell 8 percent in October compared to 15 percent growth in September before the ban, Tse pointed out.

VIP revenue, which has been declining for different reasons, fell 31 percent. Tse now forecasts total gaming revenues will slip 1.4 percent for the full year and rise 3 percent next year. However, margins will be hurt if smokers continue the shift to VIP rooms.

The result of all this new negative feeling is that Macau gaming stocks have plunged. 

Here are the percentages by which the stocks of Macau operators and their Macau subsidiaries have fallen from their 52-week highs as of this writing:

MGM Resorts-24 percent

Wynn Resorts-29

MGM China-31

Sands China-32

Wynn Macau-32

Las Vegas Sands-34

Galaxy Entertainment-40

SJM-42

Melco Crown-47

Hit even worse has been Macau casino manager and e-table provider Paradise Entertainment, falling 61 percent even though its revenues have been growing.

To all of this, we invoke the words of Roy Rogers’ sidekick Pat Brady:

Whoa Nelly.

Every one of the worries about Macau is true, and we’re glad, in a way, to see our previously stated cautions have proven their merit.

But as so often happens, investors are running the risk of reacting too strongly in the other direction, if they already haven’t reached that extreme.

Even if every current worry remains, the future should be brighter for these companies than the current sell-off justifies.

Consider:

• Burgeoning Chinese middle class is real. And, while the transition away from VIP gaming-centric operations to a more Las Vegas-like model might be difficult, it will happen.

Demographics, as they say, are the future, and the demographics of China are compelling.

• Delivering people to Macau. The network of high-speed rail lines, the bridge connecting Macau to Hong Kong and to the mainland, and the development of adjacent Hengqin Island into a national Chinese tourist destination are real, too.

• Tough, not dumb. Both the central Chinese and Macau governments might permanently toughen conditions, but they also know the financial treasure they have in Macau casinos and aren’t likely to strangle the geese laying the golden eggs.

More likely, there will be a means of mitigating the impact of the smoking ban, players and governments will adjust to stricter policies aimed at corruption, and the renegotiation of casino licenses will be resolved.

• They can play the geographic expansion game, too. As Melco Crown is demonstrating with its casino projects in the Philippines and Far Eastern Russia, Macau casino operators can venture beyond the city’s borders to capitalize on new jurisdictions.

Of course, we don’t know where bottom is for these stocks. And, to resort to yet another old Wall Street saying, you don’t want to catch a falling knife.

But the risk-reward ratio might be starting to lean towards the reward side.

For example:

• Las Vegas Sands has made the case that Macau is actually capacity-constrained. It needs more hotel rooms and gaming space, the company says.

So maybe those new resorts opening next year will boost business, after all.

• Macau casino operators have become dividend payers, some very generous, such as WYNN, now around a 3.4 percent yield not counting its special dividend, and LVS, around 4.5 percent.

Those dividends—and LVS’ big share repurchases—should help cushion the stock and reflect management confidence in their growth.

• Las Vegas is growing again and U.S. regional markets are slowly recovering—pluses, especially for MGM.

• Valuations. While the stocks are not quite in the value category, they are no longer stretched at 15 times forward earnings for LVS and MPEL, and enterprise-to-EBITDA ratios below 13 for them and WYNN.

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