Ask anybody in the hedge fund industry and he will tell you Stephen Mandel is one of the best in the business, if not the best. At the Ira Sohn Conference this May, he said he looks for two components when seeking margin of safety: price paid and strength of business franchise. If given a choice of one or the other, Mandel's preference is strength of the business.
With that in mind, let's take a look at Melco Crown.
1) Strength of business franchise? Since its IPO in 2006, Melco Crown has had a few missteps led by their fledgling management team, gaining professional experience with shareholder's money while delivering sub par returns.
- On December 16, 2006, investors' optimism enabled the 29 year-old Lawrence Ho, despite Ho's inexperience with either building or operating experience of a gaming resort, to raise $1.3bn dollars for his new resort gaming venture, valuing the entity at $7.5bn. Investors had hoped that both nepotistic benefits and Stanley Ho's (the Macau gambing tycoon, who had a gambling monopoly in Macau until the handoff to China) 40+ years of operating experience would be passed onto the son.
- School was in session with the first project, the Crown Macau (now renamed to Altira). With its contemporary minimalist design, the Crown Macau is no doubt an elegant place. Dining at the top of the hotel reminded me of high-end restaurants in New York City. However, I don't think the management team had the Chinese mass market in mind from the start because it was a stretch to believe that the majority of mainland visitors can appreciate this type of subtle elegance. It did not have the "must see" over-the-top flamboyancy that attracted the masses like the Venetian Macau. On top of that, the location of the Crown Macau was isolated and out of the way from mass market spill over traffic. So why allocate so much floor space to the mass market business? After a few quarters of disappointing operations, in 07Q4, Lawrence Ho decided to refocus on his original intent and reconfigured Crown's mass market floor space to be redeployed as VIP floor space. All in all, the Crown Macau was a misstep. Management had to rejigger the original floor design, following an already delayed opening, while costing shareholders 20% more to complete than originally estimated.
- Along with the recent Asian economic recovery, Crown Macau's business seems to have finally stabilized and will probably generate low teens return-on-invested-capital on EBITDA from here on. While not a total loss, it is still severely under performing Wynn (WYNN) and Las Vegas Sands in terms of ROIC. But hey, Lawrence Ho is only 30. I'm sure Steve Wynn and Sheldon Adelson (CEO of LVS) also had plenty of these learning experiences when they first started. But the fact remains, Wynn and Adelson made their bones when Lawrence was going out with cheerleaders (borrowing Moe Greene's line) and it clearly shows in terms of the bottom line.
2) Valuations? At 10.5x 2011 EBITDA, MPEL is cheaper than WYNN's best in class operator of 12x but roughly in line with LVS and MGM. Not an apparent bargain, you get what you paid for.
For the above two reasons, I find it puzzling that Lone Pine owns MPEL. So what other possible explanations are there?
- Bullish on Asia and wants exposure to Macau pure play? Unlikely. WYNN, LVS and MGM all do have a significant amount of their business in Las Vegas and Vegas is a drag on growth, not to mention the restrictive covenants on the subs. Maybe they own 880 HK also, Lawrence Ho's father's publicly traded vehicle. Funds don't need to file their Hong Kong holdings until they cross a certain threshold. Maybe Lone Pine owns them as a group, and I just can't see it. Can't they just wait for WYNN and LVS's Hong Kong offering for a better pure vehicle?
- Still like the gaming space but want to rotate (ie. sold LVS) into something with a more conservative balance sheet (ie. MPEL)? Unlikely. I think WYNN has the best balance sheet. Plus if the Asia gaming turns downward, a conservative balance sheet wouldn't prevent the stock from collapsing.
- EBITDA margin benefit from commission cap? Unlikely. David Bain of Stern Agee, in his Aug 12, 09 note, wrote "recently, the Macau government announced it would begin regulation of junket commissions, which should boost VIP gaming EBITDA margins for Macau casinos". If memory serves me right, I believe MPEL started the junket wars. MPEL had to pay a higher commission in order to "buy business", which was heavily criticized by Wynn. If caps are put in, doesn't MPEL's market share revert to the pre-war market clearing percentages? How does that increase their margins? I really don't understand it.
- Bullish on City of Dreams? Probably not. The Street is expecting a low-to-mid teens ROIC for City of Dreams, in line with what they did at the Crown. Will they beat expectations? Who knows. MPEL's track record isn't good, I doubt Lone Pine is hanging their hats on that project.
- New opportunity in Taiwan? Maybe. There's rumors that Taiwan may build a new casino and MPEL might be involved in that.
- Change in Macau's gaming tax rate? Hmm... interesting. Right now the gaming tax rate in Macau is roughly 40% of revenue. LVS is opening their Singapore gaming resort early 2010. The tax rate in Singapore is 15%... that's a huge difference. Keep in mind this is a revenue tax, everything drops to the bottom line. Let's assume Macau cuts their tax rate by 15% to 25% of revenues. If MPEL has the worst EBITDA margins amongst its peers, a 15% cut in taxes will double their EBITDA!!! Oh the benefits of being a laggard!!! That's a great bet if Macau were to cut their tax rates (click here for the numbers)... I guess the real question becomes... are they going to?
Disclosure: No position.