Monday, July 6, 2015

The AA Trade (MPEL)

Michael Lewis's The Big Short described one particularly effective way to short mortgages - shorting the "safer" derivatives on mortgages. There were many mortgage derivatives (e.g. senior tranches of CDOs) that were rated AA (that is, just riskier than AAA-rated US government debt). Yet, the underlying assets were of junk quality. As a result, the resulting payout was $50 to 1 invested vs. say the $10 to 1 of shorting the riskiest mortgages. Shorting Macau-based casinos such as Melco Crown Entertainment Ltd. (Nasdaq: MPEL) may be the AA trade for shorting China risk.

MPEL is a Macau-based developer & operating of casinos and entertainment resorts and makes money mostly from Chinese tourism. As Macau is the one area in China where gambling is legal, MPEL is essentially an investment in Chinese gambling. However, increasing (sticky) supply of casinos, decreasing demand from China, and a heavily leveraged capital and operating structure make a short favorable.

1) New supply comes from a near doubling of casinos from 2007 to 2013 alone:


(Source: http://www.cnbc.com/id/101258573 - not the best source, but I believe this is approximately correct). At the same time, entire new casinos are being built to be completed in 2015-2016 (http://www.wsj.com/articles/macaus-gambling-revenue-continues-to-tumble-1430718723 , http://www.nytimes.com/2014/03/26/business/international/macau-rides-high-on-new-round-of-casino-construction.html?_r=0 )

Here is the key passage:
On Wynn’s earnings conference call last week an analyst asked the company’s chairman and chief executive, Steve Wynn, why he doesn’t slow construction of the project or scale it down.
Mr. Wynn interrupted him: “Hold on. You can’t slow it down. It’s being finished and there’s bank obligations. You can’t slow it down in Macau. The building is sitting there. The skin is on. They’re getting ready to fill the lake. Staff is hired.”
This is key - increasing competition and falling revenues does not affect supply. In the face of debt and financial commitments, most developers are committed to the path.

MPEL is committed to spending its entire profits since 2005 on new projects.

They are $1.3B for Studio City Project Facility & $1B for capex related to Studio City, City of Dreams Manila and City of Dreams, against ~2B in positive gaap net income, see page 106 & F-63 of annual report with SEC:
http://www.sec.gov/Archives/edgar/data/1381640/000119312515130190/d807931d20f.htm#toc807931_76


2) Lower demand - from the Chinese government corruption crackdown, to a now falling (leveraged) stock market, the party is over (from same wsj article):

Macau’s gambling revenue fell 39% in April from a year earlier to 19.17 billion patacas ($2.41 billion), according to official data released Monday. Revenue has fallen for 11 straight months, including a record 49% drop in February, and has now declined 37% this year.
Yet, Macau is far from returning the "norm" of Las Vegas:


(http://www.asx.com.au/education/investor-update-newsletter/201404-emerging-markets-versus-developed-markets.htm)

Macau's gambling revenues can drop 90% before reaching 2004 levels. Macau was 10x Vegas even during the housing boom. Now, this is an admittedly apples-to-oranges comparison, but the key point is that Macau revenue growth has been exponential even compared to China proper. There is plenty of room at the bottom.


3) Leverage makes this highly explosive. There is operating leverage for Casinos as a whole - most costs are highly fixed in building the resort, games etc., so once a casino is built every new customer is profit (roughly). This means that when there is a flood of big gamblers from say China, casinos do well (see above graph).

There is also consumer leverage - Chinese visitors are big spenders, despite a lower per capita gdp/income in China. This is because typical vistors are VIPs, the super-rich.



http://www.statista.com/chart/1455/macau-makes-10-times-more-revenue-than-vegas-per-visitor/

What happens if this reverts to a more normal (yet more rich? USA levels)?


For MPEL, there is the operational leverage of being 100% China/Asia, as well as the financial financial leverage of taking on debt
http://financials.morningstar.com/ratios/r.html?t=MPEL&region=USA&culture=en_US


Much of this write-up was macro-focused, and that is no accident - this is a macro trade expressed through a usa equity. MPEL is simply (one of) the least diversified company, most levered casino operator I've seen. Macro investors are focused on shorting the yuan/aud, iron ore (more of a short bbb trade), equity indices in China, shibor swaps. Equity investors are focused on monthly revenue data, new casino builds, costs of new casinos etc. They see the last 3 years and hope for "normalization" (http://online.barrons.com/articles/macau-casinos-time-to-bet-on-the-house-again-1418977279).

That is the edge here.


Valuation:
$1 is a placeholder for debt-restructuring. I believe the revenue tide will (continue to) turn violently in the other direction and wipe out gaap & even ebitda margins. The equity will probably reflect this well before any covenants are actually triggered. The severity of revenue change expected by this thesis makes detailed modeling unnecessary, in my opinion.

For example, say revenue per customer gets cut in half (still much higher than Vegas), not unrealized given the 40%+ annualized drop seen in months earlier this year and revenue reverts to 2010 levels. MPEL is breakeven on a gaap basis or worse.


Catalyst:
Time & bankruptcies proceeds. As this is a macro-themed trade the psychology/reflexivity of price-action can be its own catalyst. For example, margin call selling of stocks by Chinese (retail) investors puts further pressure on stocks and finances of the Chinese populace as a whole. Fewer people go to gamble when many are wiped out by the other casino (the stock market).


Risks:

1) China double double double...downs and succeeds: stimulus even beyond current levels could possibly restart the investment engine. However, I believe the recent state-sanction equity injection (7/7/2015) in the stock market has finally shown where China's reach has exceeded its grasp. It is as if Obama asked Goldman Sachs to buy stocks, then the market falls. Regardless, the exponential growth of of MPEL/Macau makes future growth difficult to achieve - especially given that competitors are trying to grow as well (http://www.reuters.com/article/2014/03/12/us-macau-expansion-idUSBREA2B09D20140312 , http://www.wsj.com/articles/macau-gambling-continues-to-drop-1433140493)

2) Currency devaluation - part of MPEL's debt is dollar denominated (p. 24 of 20-F/annual report), so liabilities actually worse as revenue is derived from Chinese exchanging yuan into hkd.

3) Buyout - unlikely given the debt-load and that plenty of casinos are already building - why buy when you can build using cheap materials (steel)?

4) Reversal of smoking/visa restrictions. China recently eased visa restrictions to Macau, allowing Chinese to visit Macau more often. To me, this is like telling homeowners in 2008 that they get a 20% discount on flights to Vegas. Vegas still lost money.


Conclusion:

This write-up is meant to be approximately right rather than precisely so and is meant to be a hybrid investment, macro expressed as single equity. As such, it depends on hitting the overall view (China short) while expressing it in a capital efficient way (many ways to profit).

Careful investing to all

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