Asia Entertainment & Resources: Short-Term Weakness Offers Long-Term Potential

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Asia Entertainment & Resources Ltd. (AERL) is a Micro-Cap company that operates VIP gaming rooms in three 5 star hotels in and around Macau. They specialize in capitalizing cages for high stakes baccarat play. It funds VIP cages with cash and 0% loans, and then collects a fixed percentage of Rolling Chip Turnover from these cages.

AERL differs from traditional gaming companies is in its ability to immediately reinvest accumulated income to grow cage capital. By deploying income back into the cage, AERL is effectively compounding its returns. There is also the ancillary effect of making it easier for casinos in which AERL operates to loan more money at 0% as the VIP business grows.

AERL reinvests 85% of net income into its cages. It pays out to investors the remaining 15% as a semi-annual dividend. A $.12 dividend having already been paid to existing shareholders, over the next six months investors can expect an annualized yield in excess of 8%.

AERL makes money by attracting VIP clients to their gaming rooms and they deploy a network of agents to accomplish this. Players use special chips and casinos keep track of how many times these chips are used so they can then pay AERL a 1.25% commission. This tracking of chips is called the Rolling Chip Turnover (RCT). Because AERL makes a commission based on RCT, it is in their best interest for players to play longer and win more.

The first six months of this year saw an increase in AERL's Rolling Chip Turnover of 20% year-over-year to $10.0066bil from $8.406bil in 2011. That represents, after expenses, a six month haul of $97.5mil. Shares, however, were crushed as June RCT numbers declined 9% year-over-year. That decline compared with a 3% decline in RCT for Macau casinos in the same month.

AERL reports its RCT rates monthly and those numbers are audited by the casinos they partner with. Monthly reporting allows shareholders some insight in how day to day operations are continuing. In June, VIP traffic was down thanks to the European Cup and Wyatt casino reported a higher than expected win percentage.

A casino showing consistently higher than expected win percentages is not only unlikely, but could suggest cheating. Thanks to monthly reports, AERL makes identifying unusual results easier and allows management to react appropriately.

With a twelve month trailing return on investment of over 40% management seems more than capable of increasing shareholder value. This company has a share float of less than 21 million shares and is trading below book value. Management predicts continued 20% year-over-year growth, suggesting the company will generate net revenue of $195mil.

In addition to the organic growth caused by reinvesting 85% of net income back into cage capital, AERL recently completed a trial operation promoting the first luxury VIP rooms on Jeju Island in South Korea. AERL may work again with MGM Macau. Previously AERL maintained a win-based revenue VIP room for MGM, but closed operations in favor of RCT revenue streams. MGM has shown interest in opening turnover-based VIP rooms.

When evaluating the risks specific to AERL it is important to understand what affects Rolling Chip Turnover (RCT) numbers. AERL collects a 1.25% of the total RCT numbers as a fee. It uses .78% of that fee to pay commission to its agents responsible for bringing VIP players into AERL controlled rooms.

These agents must bring enough quality players into AERL VIP rooms to ensure high RCT numbers. AERL makes more money with larger bets over longer periods of time and has been able to consistently turn chips 6 to 8.5 times over. The most recent decline in RCT is troubling because it could signal a deterioration of AERL's agent network. Fortunately for investors, AERL reports RCT numbers every month and any such deterioration is made easier to track.

The win percentage of casinos will also impact AERL's earnings. AERL hopes players play longer, requiring the use of their chips longer and in greater amounts. It was an unusually high casino win percentage that contributed to AERL's poor July RCT numbers. If casinos are cheating to increase expected "hold" (casino win percentage) rates then AERL's commission based business model would suffer.

Because of the commitment to reinvest 85% of income after commissions are paid; the faster AERL can collect fees from its agents, the more RCT the company can generate. That means that any delay in fee collection will lower both company growth (limiting cage capital) and reduce RCT numbers. AERL currently requires agents to return fees to them within 30 days. The average return date is about three days less than 30.

With those risks in mind, AERL offers a compelling investment. An investor today could expect a dividend yield in excess of 8% and would buy a company with .38 cents of cash per share on its books.

As China development moves north and west across the county, construction-related wealth is created. China's VIP players are also typically cash rich, with large amounts of disposable income that contribute positively to collection times and RCT. AERL projects 20-25% growth in RCT numbers for the year. They should be able to maintain a 15% growth rate into the foreseeable future.

Disclosure: I am long AERL.

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