Macau's Gaming Industry Has A Problem

| About: MGM Resorts (MGM)
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Summary

Macau is changing. What was once a cash cow for casino companies is now increasingly likely to become a future liability.

The rise of China has drawn US casino companies to the islands of Macau with large short-term gains, but the good times are coming to an end.

Long MGM; short LVS.

I recently wrote an article on why Las Vegas Sands (NYSE:LVS) is the best short trade for riding the sliding Macau casino industry. Shortly afterward, I was asked whether the gambling industry has any good long trades. I believe that now is an appropriate time to answer this question, as the summer months tend to be good to the industry.

Indeed, a better and safer trade for leveraging the changing demographics of the international gambling industry is a pair trade - specifically, one with a short leg highly exposed to Macau and a long leg not so much. For this purpose, I recommend pairing the LVS short leg with an MGM Resorts (NYSE:MGM) long leg.

Exposure

In my previous article, I mentioned LVS being the market leader in Macau. Indeed, the company holds over one-third of the market share and is growing. On the other side of the spectrum is MGM, which has held a constant 10%:

As Macau falls, it should hurt each company in proportion of its market share. But investors should also understand more than just market share - "Why is Macau's gaming industry falling" should be a question asked before considering any trade. The issues are numerous, but are mainly related to governmental policies and are therefore unlikely to change anytime soon.

The primary issue is that Macau is attempting to renovate its economy and its image. Presently, the government's main source of income is gaming tax. The small, connected set of islands hopes to turn itself into a tourist destination, a la Las Vegas, instead of a pure gambling destination.

Anyone who has been to Macau understands that the region is rich in culture. They would also agree that attempts to convert the region into a tourist destination are unlikely to find success. Mainland Chinese, the reason for Macau's excessive growth, must fly from the mainland to reach Macau - and if they are to board a plane, why not go to one of the already established tourist destinations in the area: Japan, Taiwan, Korea, Thailand, etc.?

Macau wants to be Las Vegas, but the transition will require more than a few testosterone pills. Las Vegas is already a huge draw for Asians, and a "poor man's Las Vegas" simply doesn't have the attractive or prestige factor that a trip to Tokyo or actual Las Vegas does. The mainlanders have their own Las Vegas type resorts and shows in the mainland and are unlikely to be persuaded that Macau offers anything more than gambling.

More importantly, the huge influx of Chinese money from the upper classes is dwindling. Socially, this is good, as much of the monetary pass-through was money laundering. However, economically, this has hurt Macau and the companies positioned in the region:

Effects on LVS and MGM

LVS has been punished. Its EPS is falling quickly. We see LVS's seasonal EPS tilted on a diagonal, implying an overall downward trend in earnings:

MGM, in contrast, has maintained its seasonal EPS trend, moving sideways:

Thus, the summer bounce we see in casino stocks is likely to hold for MGM but might not so for LVS, assuming investors consider the YoY growth in EPS. Summer seasonality begins in July, and MGM's stock follows, with an average gain of nearly 10% over the three months from July to November. Each month has a 65% chance of gains:

While the same seasonality has been seen in LVS, holding a long position is not advisable, especially as this period covers earnings. Again, the strategy in question is a pair trade, so in a sense we are hedging for seasonality anyway. Long MGM and short LVS is actually quite an exemplary pair trade because the companies are so similar except for Macau exposure.

MGM has half the Macau exposure that LVS does. MGM's exposure has been declining while LVS's grows:

Conclusion

As Macau forces casino companies to focus on the resort aspect - not the gaming aspect - of the business, those with significant exposure to Macau will pour over the numbers and quickly see that a resort business is Macau makes as little sense as a resort business in Taipei, Anhui, or any other area with a rich culture, good food, but really nothing to do for fun. While a resort business works in Las Vegas, which has droves of non-gambling tourists, it currently does not work in Macau, which is seen as merely a gambling destination. Companies such as LVS and MGM will begin to regret not having expanded in Las Vegas instead, as this is where the resort business is flourishing, with non-gaming revenue overtaking gaming revenue in the late '90s:

With LVS, Wynn Resorts (NASDAQ:WYNN), and MGM all set to open new properties in Macau, oversupply will hurt individual company profitability, playing another factor in earnings decay. MGM's new property will open in 2018, but until then (when investors see a divergence of post-opening guidance and pre-opening expectations), MGM is a good long leg of a gaming pair trade. Long MGM; short LVS.

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