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If I said I knew of a company whose stock is priced near its 52 week low and is trading below 3x 2011 EPS, that will generate approximately $2 a share in FCF this year and $3 in 2012, one thought would likely come to mind. "What are you not telling me?" If I added that the stock is currently yielding over 6% (that’s right, it pays a dividend), would I have your attention? The company is Asia Entertainment & Resources (AERL), a gaming promoter company doing business in Macau’s red-hot casinos. For a more comprehensive understanding of the business go to AERL’s website, and click the Analyst Report tab under Financial Information. Sterne Agee analyst David Bain does an excellent job of explaining the nature of this compelling story.

For those of you who are suspect about what have been generically been referred to as "Chinese small caps," let me explain why it is a mistake to categorize AERL this way. First, AERL’s business is governed by the laws of Macau’s Special Administrative Region (SAR), making the contracts the company has engaged in fully enforceable. Unlike in China, AERL’s management is exposed to the threat of lawsuits should it violate its fiduciary responsibilities to its shareholders.

Second, AERL operates in the public domain for all to see, in casinos. Management welcomes potential investors to visit the VIP rooms it operates and speak to both AERL and casino officials. The owners of those casinos, publicly traded companies like Las Vegas Sands (LVS) and Galaxy, have chosen to partner with AERL not only because the company is well capitalized but because of the added transparency AERL brings to the table as a similarly publicly listed company. Ask yourself if those major casino companies would jeopardize their standing in Macau by doing business with a promoter company that was not completely trustworthy. After all, they don’t have to. The casinos have many promoter companies to choose from.

Third, there is a high degree of redundancy in the verification of reported revenue. Gaming is a highly regulated business everywhere and Macau is no exception. Multiple parties are involved in the creation of an extensive, detailed paper trail including the casino operators, the Macau taxing authorities, and gaming regulators who review and verify the daily documentation created at the casinos. This is done to account for each day’s activities in the casinos. These documents are available to AERL’s auditors who receive additional authentication of revenues from the casinos when preparing the annual SEC filings.

Fourth, in order to substantiate its strong cash flow, AERL’s management recently initiated a dividend policy paying out 15% of annual non-GAAP net income. Furthermore, management has committed $60M of its own money to boost cage capital, the amount of money AERL has available for casino patrons to gamble with. Cage capital grows each month as profits are re-invested back into the business. The growth of cage capital in turn facilitates a higher revenue stream for the following month, creating a virtuous circle.

Clearly, AERL has distinguished itself from the pack due to the transparency with which it conducts its business, and business is good. Consider the following recent developments:

  1. Net income guidance was raised to the upper end of the previously indicated range in the wake of a higher line of credit given to AERL by one of its casino partners.
  2. AERL has received analyst coverage (see the report available at its web site) with a $22.50 price target based on peer valuations and 12x estimated 2011 EPS. My work suggests EPS could be in the area of $2.20 on a non-GAAP basis.
  3. RCT (rolling chip turnover), the metric used to measure the monthly success of the business, has hit a number of record highs this year. The monthly release of this number further enhances transparency and visibility of earnings.
  4. With Macau’s gaming capacity slated to expand in the coming years, AERL will be among the first companies considered to operate new VIP gaming rooms upon their availability due to AERL’s status in the industry. Industry analysts expect Macau to grow from 10-20% for the next 5 years.
  5. The company has also put a buyback program in place, putting a floor in the stock price.

Conclusion, AERL represents the rare combination of an undervalued stock with the safety of a high yield and excellent potential for capital appreciation.

Part ll

Disclosure: I am long AERL.

Source: Asia Entertainment & Resources: Undervalued Stock With The Safety Of A High Yield