Debt, Competition and Government Control: Is Melco Crown Worth the Gamble?

| About: Melco Resorts (MLCO)
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Melco Crown Entertainment (MPEL) is a casino operator in the Macau enclave off the coast of China. It competes with SJM, MGM, Las Vegas Sands' (NYSE:LVS) Sands China, Wynn Resorts' (NASDAQ:WYNN) Wynn Macau, and Galaxy Entertainment. The company's two main properties, the CIty of Dreams and Altria Macau, are completed, have both been open more than a year, and results are improving.

Investors in Melco, however, have not been rewarded for gambling on the company. After pricing an IPO of 60.25 million ADS at $19 in December of 2006, shares tanked to $2.50 at the March 2009 lows, and are currently fetching $6.82. Longer construction times, higher costs, and financing concerns have weighed on the share prices. But now Melco Crown is on the verge of becoming profitable, and investors may be rewarded for rolling the dice.

For all of 2010, Altria Macau reported operating income of $95.1 million, with an average daily room rate of $166, for a 94% occupancy rate. Altria Macau, which has 550 slot machines, 220 table games, and 216 rooms and suites, caters to high end customers, and is the smaller of Melco Crown's casinos. City of Dreams reported operating income of $108.6 million, with an average daily room rate of $157 and an 80% occupancy rate. City of Dreams is the crown jewel of the company, featuring 400 table games and 1,300 machines in a 420,000 square foot casino. It features a Hard Rock Hotel and a Hyatt Hotel, and the property has 2,200 rooms and suites. It also features the shopping and stage shows that American gamblers who have been to Las Vegas have come to associate with large casino properties.

Total 2010 revenue for MPEL, which includes its Mocha Clubs and House of Dancing Water show, was $2.6 billion, up from $1.3 billion in 2009. City of Dreams opened in June 2009, and its full year of operations in 2010 was a big driver in the year over year change. Loss in 2010 was $10.5 million, or $0.02 per ADS, compared to a loss of $308.5 million, or $0.63 per share in 2009.

The main driver of growth for Melco Crown, and for all of Macau, is the Chinese gambler. Macau is the only place in China where gambling is legal, and the government has tight control over the region. Most Chinese citizens are limited to two trips per year to Macau (residents in the Guangdong province had restrictions eased to one trip per month in 2009), and the government is not giving out new casino operating licenses. There is a ban on advertising gambling explicitly, which Melco Crown has gotten around by using the House of Dancing Water stage show to get its name out. Total gaming revenue was $2.3 billion in January 2011, up 33% year over year, as the region continues to attract more gamers. The opening of Galaxy's new Macau casino in the second half of this year should support a rise in overall gamers in Macau.

Melco Crown faces several headwinds, and some of them are cause for concern.

The first is the company's debt. Currently carrying $1.84 billion in debt, Melco's net debt to shareholders equity stands at 49%. Interest payments and other finance costs were about $103 million in 2010, eating up all of the operating income the company generates, and causing the yearly loss. Add to that the fact that interest expenses tripled in 2010 from the year earlier, and that is a troubling sign indeed.

The second major hurdle is the opening of the new Galaxy property, sometime in the latter half of this year. This increase in competition will draw some people away from Melco's casinos for a time, as people opt to check out the new property.

The third possible issue is the Chinese government itself, but only to an extent. By being able to limit the amount of trips Chinese citizens can make to Macau, Beijing has huge control over the profitability of the casino companies in Macau. A tightening of control over travel would be devastating for Melco and the other casino operators, while a loosening of travel restrictions would greatly increase profitability.

It seems Melco Crown is an interesting wager. On one hand, the company is poised to become profitable for a full year for the first time in its history. Melco has used proceeds from the IPO 4.5 years ago to build large, glamorous facilities in the new gambling hub of the world. There are 1.3 billion Chinese customers located just next door, not to mention growing populations in other Asian nations. Revenues continue to grow month over month in Macau, with no end in sight.

On the other hand, the Chinese government has tight control over travel into Macau, and has not shown any interest in changing that control. Competition, while limited, is fierce, with a new property commencing operations later this year. Debt used to fuel the build out is high, with interest payments eating into the Melco Crown's cash flow.

Trading at $6.82, Melco Crown (MPEL) may be a high risk, high return wager, but investors better have a strong stomach.

Disclosure: I am long MPEL.