In my recent article on Asia Entertainment and Resources (AERL) I covered what I felt are some of the significant reasons making the purchase of AERL stock an attractive investment, focusing primarily on the kind of transparency that should bring comfort to potential stockholders, something management has worked hard to establish. As a follow-up to that piece I thought I’d go into more depth about the business model and explain in more granular detail the nuts and bolts of their business.
First, let me quickly explain its role in the Macau gaming scene. Promoter companies like AERL, licensed by the Macau gaming authorities, sign agreements with casino owners to operate individual VIP rooms in the casino where high stakes baccarat is played. The agreements call for AERL to do a pre-determined, minimum level of VIP business in those rooms. In exchange for that service the company is paid each month based on a percentage of what is known as rolling chip turnover (RCT). RCT is a measure of the volume of gaming that has occurred.
AERL makes public the RCT level it has attained in a monthly press release, achieving two purposes. The more obvious one being it gives investors a clear indication of the amount of business AERL has done for the trailing month. But it also represents the success the company has had in collecting the money owed it by VIP clients. This is important because the business is run on a monthly cycle, having capital to loan to patrons for gaming at the start of the month, and then recouping the patron’s debt and being paid by the casino at the end of the month. Without the successful, timely collection of debt (DSO’s are referenced in a report from Daiwa) the company would not have been able to achieve the results it has had in the last few years. Which is where the story gets very interesting.
The amount of money AERL has to loan to its patrons at the start of each month is referred to as cage capital. The more cage capital it has the higher the RCT number can potentially go and consequently the more profit the company can make. At the end of the third quarter last year cage capital stood at approximately $90M. Since that time it has grown markedly, by virtue of cash received from the redemption of warrants ($35M), a zero interest loan from the company’s founders of $60M, increased lines of credit from the casino companies it has partnerships with ($55M), and the reinvestment of profits from each month’s operations. While AERL has not yet reported for Q3 2011, I estimate it ended the quarter with more than $230M in cage capital.
At this point I want to direct your attention to something I touched on briefly in the prior article on AERL, the virtuous circle of reinvested profits. Management’s decision to plow profit back in to the company enables the growth of cage capital each month, creating a compounding effect that allows for organic growth of revenue. As I mentioned, the more cage capital it has the more money it can make. And the more money it makes the faster cage capital grows. Does it get any better than that? Yes, I believe it does. Because not only is it clear earnings will grow, modeling for future earnings is a relatively easy task.
Doing so goes like this. Take the cage capital figure at the beginning of the month and multiply it by the rate at which that money is "turned over" in the VIP rooms during the month. The rate varies somewhat but typically falls within a range of roughly 8 to 9. This equation allows you to arrive at the RCT number for the month. For example, start with cage capital of $200M, multiply by an average turnover rate, 8.5, which gives you $1.7B. So $1.7B is the RCT for month X. Once you know a month’s RCT you can determine AERL’s net income for the month by multiplying RCT by the percentage that goes to the bottom line after SG&A expenses, or 0.4%. That percentage is standard for the industry, a figure a number of promoter companies listed on the Hong Kong exchange reported as their compensation in their filings. So, AERL’s net income for month X is $6.8M. Add that amount to the previous month’s cage capital number, repeat the aforementioned mathematical exercise, and you can see the organic growth of earnings unfold. My model indicates 2012 non-GAAP EPS of around $3.00, accounting for an anticipated $25M line of credit increase I’m assuming will concur with AERL operating a new VIP room as of the beginning of Q2 next year.
Look for AERL to report what could be a record RCT number for October due to the impact of the Golden Week holiday. Reports out of Macau suggest October was the strongest month so far this year for total gaming revenue. The press release AERL issues usually comes by the third of the month. Also look for Q3 results to be released in the first half of November. It should be another excellent quarter.
Clearly one has to be cautious about looking too far ahead in making predictions for any business. AERL’s success is undoubtedly tied to economic growth in China. Recent concerns about that rate of growth caused an unwarranted decline in all the gaming stocks with operations in Macau, Melco Crown Entertainment (MPEL), Las Vegas Sands (LVS) and Wynn Resorts (WYNN), not long ago. The stocks of those companies have since rebounded as analysts and company executives dismissed China growth-related worries as overblown. To date, the promoter business in Macau has been unaffected by current conditions in China.
Taking all of this in to consideration I believe AERL stands as one of the most intriguing small-cap plays in today’s market.
Disclosure: I am long AERL.