Not many people win when they bet against the house. Not many people win when they bet against China. I'm about to tell you why I'm doing both.
Obviously, names like these are going to be crushed during huge depression style collapses like the Great Recession. But both have come back stronger and more vibrant than ever thanks to the little Chinese administrative region of Macau.
The history of Macau, which is better explained by Wikipedia is nothing short of a modern day gold mine. Gaming revenues have exploded to the point where gamblers in this region spend one year of Las Vegas revenues in about 7 weeks. As in Vegas, casino licenses are tightly controlled by the government and those fortunate enough to have secured one have made billions in an awfully short amount of time. WYNN and LVS revenues have gone up exponentially as have their stock prices. Estimates on Macau gaming revenue are continually being raised.
Expansion is ever growing. Casinos are still pouring cash into Macau in record amounts for new complexes not slated to open until the middle of the decade.
Of course, some Macau bears (of which there are few) point to the fact that there is some talk of additional licenses being granted for greater competition, as well as nearby countries opening up gaming for a piece of this pie. There is also the ever-present concern that authorities could raise the gaming tax above its current level of 38% even though that specific tax is in place for the next 8 years. New York City's tax is almost twice that, for comparison's sake. China may simply put their foot down on profitable foreign entities as they have done in other sectors like they have already done to Apple, GlaxoSmithKline, Mead Johnson, etc.
But we're not going to discuss that because, ultimately, it won't even matter. Let's instead look at what has been driving growth, specifically cheap money inflows, capital flight, money laundering, and of course gambling.
China (or at least its SOEs and party elites) has been the recipient of huge amounts of low interest money for a decade in the form of government stimuli, household financial repression, foreign investment and illicit carry trade. This has led to a well known, albeit less-agreed upon, credit distortion. Some claim asset bubble, others mis-allocated investment dollars, but without a doubt it has unbalanced the economy to the point where household consumption only contributes 36% of China's GDP.
This had created huge wealth for the few elites, lifted hundreds of millions out of poverty and made China a growth driver for the world economy. But that ride is coming to an end. With EM collapsing, the Fed ending tapering and the PBOC aware of the risks it has on hand the free money days are over. China needs to rebalance for its own sake (a quick read here) and it doesn't have a lot of time.
The easy money that had driven casino expansion, gaming revenues, luxury mall purchases and tourism is at an end. To some extent casino operators acknowledge this and are trying to lure middle-class families but we'll address that later.
If you can agree that cheap money and government over-investment is winding down, then you can probably agree that at the high-end there will be less euphoria in the gaming market.
Capital Flight & Money Laundering
It's no secret that the rich have been hauling money out of china by hook or by crook in massive amounts. Attempts to disclose the wealth amassed by party elites have left Bloomberg and the New York Times shut out by the Great Firewall of China.
One third of Chinese millionaires have already left the country. Two thirds of the rest want to.
It's probably not good when the people who build your neighborhood refuse to live there, but that's another story.
So how is that money snuck out of a country with such tight capital controls.
- The Chinese high-rollers deposit money with junkets (think VIP hosts married to luxury tour operators) within the borders of the mainland and withdraw from those deposits at the Macau office of the junket. Alternatively they can withdraw from lines of credit created at the Macau office.
- Once the money is withdrawn it is brought to the casinos, naturally, where it is converted to chips and "gambled."
- Chips can be then redeemed at the casinos for physical US dollars.
- Junket operators lay claim to the Yuan at the mainland branch and are made whole plus a not-unsubstantial fee for their work (plus the usual casino kickback - up to 40% of the VIPs loss) - oh yeah, they also use Triads to collect their debts since what they're doing is not totally, you know, enforceable.
- From Macau the cash can be invested, properties bought, or just plain rolled off in a suitcase - it's safe to assume the junket operators have a well-oiled assembly line to accomplish this, as they are in charge of the visas, transportation, and accommodations as well.
- And just like that, the money is gone.
Am I simply overstating an unpleasant, yet negligible problem? Maybe, but The Congressional-Executive Commission on China Annual Report 2013 states that over 200 billion dollars of ill-gotten funds are channeled through Macau every year.
Furthermore, thanks to Wikileaks we know that the diplomatic powers that be believe "[Macau's] phenomenal success is based on a formula that facilitates if not encourages money laundering."
If you're not a high roller with a junket to do all the heavy-lifting, you can always go to a pawn shop, buy something expensive with a debit card (Yuan) and immediately return it for cash (Dollars). Yes, that is actually a thing.
The money even finds its way into American politics
Unfortunately, for the thesis here, this also presents a big risk for shorting the casinos. While trillions have already left the country, there may be trillions more to go. While there has been talk of tighter currency regulations between China and Macau, it has remained just that and probably will for some time. When the people writing the laws are the same people that need to get money out of the country closing the biggest Money-Laundering Highway is probably not so popular. I'll remind you of this risk later.
So we know LVS and WYNN have a large portion of revenues coming from a place where a large part of those revenues are due to money laundering and capital flight. Right about now is where the 30 P/E starts to look massive.
Now there is real gambling in Macau. Lots of it. But where is it from?
Back in 2011, The Economist had a better article than this one where they state that VIPs contributed almost 75% of Macau casino revenue. You should read that here.
It's also worth pointing out that they were pointing out some of the same arguments I'm making over 2 years ago. In that time span the stock prices of LVS and WYNN have doubled. So obviously timing here is key. However, the difference between then and now is cheap money is ending, we're starting to see EM panic on the edges and the PBOC hasn't figured out how to manage its money supply. But I digress.
While VIPs still make up the lion's share of revenue, the casinos are prepping for a transition to a more "middle-class" customer by building malls, amusement parks and all the other kitschy attractions that drive families to Vegas.
In reference to the middle class: "In the next two to three years it is going to be the next wave of the golden age of Macau," says Lawrence Ho of Melco Crown Entertainment (Another great short: MPEL)
But here's the thing: the average income in China (from the Chinese Household Finance Survey 2012) is about $2100. That's per family. Even in rich Shanghai, it's about $4700. This is from China's own data set, which means these are best-case scenario numbers.
The cheapest flight to Macau from Beijing is a few hundred bucks, or you can take the train I suppose - but you get the picture.
China also has over 120 billionaires that contribute to that average, as well as millions of impoverished farmers - but I've yet to see the income distribution curve that says China's middle class will have any chance of filling the void left once the high-rollers are safely out of the country.
Before concluding, let's look at some of the risks to shorting casino stocks based on the premise that their profits and P/E ratios are inflated due to cheap money, money laundering, capital flight, and an unstable Chinese economy:
Big Risk 1: Billions more flow through Macau before the last train leaves the station. As monetary policy and money supply are tightening Macau shows ever higher revenues as junkets push and push VIPs to get out while they still can.
Big Risk 2: China enacts a major new stimulus to forestall the impending debt crisis; further inflating asset bubbles and driving more excess profits to the casinos as well as party elite capital flight.
Big Risk 3: The US panics and reverses QE taper. Cheap money inflows and export/carry trade continue to finance investments with ever decreasing returns.
Big Risk 4: The whole thesis presented here is incorrect. China and its leaders are able to successfully rebalance and move several trillions from the assets of the state to the household sector. The upper class continues to gamble with reckless abandon and any shortfalls are made up by a middle class that has sprung up overnight and wants to try their luck at the tables.
But now let's look at some facts:
Big Fact 1: Chinese depositors are clearing out bank accounts to invest in crazy-risky WMPs and demand deposit accounts at Alibaba and Tencent. The state's endless supply of household led cheap money is diminishing.
Big Fact 3: The opacity of WMPs are starting to wreak havoc on the market; Credit = Gold WMP had to be bailed out by a "mystery" savior. There are over $15 billion in WMPs due this year in the mining sector alone.
Big Fact 4: The US is tapering. QE3 is coming to a close. The Fed is ending policy of cheap money for all. EM weakness is being seen across the board.
Big Fact 5: China's economy must rebalance away from investment-led growth to consumer-led growth. Something they admit and have yet been unable to do. Rebalancing will most probably lead to slower growth over the short term.
Big Fact 6: LVS and WYNN have P/E ratios of about 30 based in part on the growth in China. Over two-thirds of their revenue comes from Macau.
Big Fact 7: LVS and WYNN are betting big on the middle class to pick up the slack and doubling down on investments in Asia.
Big Fact 8: Average income per family in China is about $2100
Big Fact 9: China is making up the data. Even Li Keqiang says so - he's the Premier of China. They seem to always be within a tenth of a point or so of whatever target they're after. Pretty amazing in a country of 1.3 billion with no transparency whatsoever. It's also interesting that until last month they had no idea how much debt was in their municipalities until a massive audit that took several months and tens of thousands of auditors delivered the data. The data that was released is most probably made up too.
Big Fact 10: The party elites have amassed huge sums of wealth and are fleeing the country with that money by the tens of thousands.
So, there is a compelling reason to think there is substantial structural weakness to the future revenues of casinos with major Macau exposure. There are also substantial risks, not the least of which is timing.
- Macau is the driver of growth and contributes a majority of revenue for LVS and WYNN,
- The stock prices of the casinos reflects a price to earnings ratio that assumes continued rapid growth in Asia,
- China has been a major beneficiary of loose money policies that are now coming to an end,
- China cannot invest its way out of its slowing growth,
- China must rebalance its economy, which will most probably slow growth further,
- Macau is a destination for party elites to launder money out of the country, and,
- China's domestic debt situation is finally at a head.
- LVS and WYNN will show declining growth in Asia at an increasing rate,
- P/E ratios will need to contract,
- Further investment in Asia will be a near-term liability, and,
- Stock prices must fall. Dramatically.
At least, that's what I think.
"It occurs first very slowly, then all at once."
Disclosure: I am short WYNN, LVS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.