Is A Crackdown On Macau Fact Or Fiction?

Includes: LINU-OLD, MLCO
by: Douglas Hoyt

Anyone paying attention to the stocks of gaming companies (LVS, MPEL, AERL, WYNN, and MGM) knows about the recent spat of articles focused on Macau. Most notable among them was this WSJ piece. The central theme being a long called for "crackdown" on corruption by the new Chinese government is going to have a negative impact on revenue in Macau, the only place in China where casino gambling is legally allowed. More specifically the author made mention of an investigation regarding illegal gambling in the mainland, tying it to Macau by reporting that some junket operators, who do in fact work in Macau, were detained as part of the investigation. What is not made clear is the illegal activities the authorities were concerned with have nothing to do with Macau or the way business is conducted there. Yet, it was the article's contention that this somehow represented a "tightening of the reins" on gaming. Is that assumption an accurate reflection of what it happening on the ground or speculation?

First, let me address the well-worn, negative characterization of gaming promoters, or junkets. They are often referred to with words like "shady," a tongue in cheek way of implying they have connections to organized crime groups known as triads. An important consideration since these junkets are responsible for almost 70% of Macau's gaming revenue by bringing high rollers in to the casinos. Suggestions of criminality certainly make for juicy story lines but does it reflect the contemporary reality? Not according to one of the major players in the industry. And it is not just that the financial rewards for engaging in illegalities are minimal, or that China's extensive shadow banking system offers many ways of transferring funds out of the country. There are also risks to losing one's livelihood. The presence of U.S. owned casinos in Macau starting in the early 2000's has ushered in a new era. Nowadays, casino floor operations are closely monitored not only by the casino's owners but also by local authorities. It would be naïve to think criminal elements have been eradicated completely, just as naïve as it would be to think they still play a major role in Macau.

The only material change to the way business is done to date is the DICJ's (the gaming authority in Macau) requirement enhancing record keeping on the part on junkets. Reuters has reported that new guidelines were circulated by the Macau Gaming Inspection and Coordination bureau on November 8, requiring junket operators to "report accurate monthly lists of players, including details of when plays were made and how much was won or lost." Here is how two industry analysts view the measures taken by Chinese authorities thus far. Even more telling are these comments from Bai Zhijian, director of the Central People's Government Liaison Office.

All of which begs the question whether the somewhat dire predictions for Macau's gaming business will come to fruition. So far the actual results are as follows; overall revenue for the month of November was up 7.9% YoY with VIP rolling volume up 7%, VIP's best YoY volume gain in 5 months. An initial report on December's results so far indicate the month is off to a strong start causing one industry analyst, Sterne Agee's David Bain, to increase his estimate to a 16% YoY jump in revenue. If he proves to be correct it would be the second highest monthly revenue number ever in Macau following the record set in October of this year. Looking a little further out, HSBC is calling for 13% growth in 2013, part of a growing consensus in the analyst community for a better 2013.

The immediate improvement in conditions comes as macro economic numbers in China shows signs of a rebound after months of slowing. China's lackluster GDP growth has been the primary reason for the decline in VIP roll, given the historically high correlation between the two. A more conservative policy of credit extension to VIP clients on the part of junket companies like AERL has also contributed to lower roll. While the VIP business in Macau remains in "show me" mode the early evidence suggests that once again the media have it wrong. Just as it did in the summer of 2011 when cautionary articles appeared only to be followed by a record amount of business in the fall. The more likely scenario is VIP roll, and Macau's revenue numbers generally, will improve in conjunction with the Chinese economy as it has in the past.

Now that the governmental transition in China is complete and the economy appears to be recovering there are opportunities for investors to capitalize on a potential rebound in gaming revenue in Macau. The mass market has remained strong during 2012 even as VIP has pulled back. Analysts expect the mass gaming side of the business to have continued strength due to an infra-structure build out making it easier for Chinese patrons to get to Macau. MPEL is extremely well positioned to take advantage of this trend and is especially attractive based on a relative valuation to its peers. For value investors, AERL's extremely low p/e, discount to book value, and estimated yield over 7% represents a compelling chance for both income and capital appreciation if the VIP segment recovers as expected.

Disclosure: I am long AERL, MPEL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.