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

Dividends don't matter (that much)

One popular investment strategy is income investing - investing in stocks that pay a steady stream of (growing) dividends. This way, you are most likely to get some money back after investing. 

More generally, a popular argument to investing in a particular security is that it has a high dividend, etc.; but why should this matter? If the goal is maximum total return while minimizing risk (whether permanent loss or even price fluctuations), why should getting back money so quickly be a priority?

There are a few reasons that people put forward, but I don't think they are as straightforward as they might seem.

1) Stable companies have good dividend histories. Dividends are a proxy for well-run businesses with good prospects; if that is the case, why not focus on the business value in the first place? 

2) Want income for daily needs. Dividends are not guaranteed, and for any specific security can vary greatly by year; in fact, those securities with the highest dividends frequently lose prinicpal (see mortgage reits in the recent year). Once again, business value (i.e. future earnings prospects of the company) matter most.

Furthermore, dividends are taxed at least 15%+ while sales of stock (depending on tax basis) may be considerably less. 

3) Companies don't have better use for the capital and frequently misuse it, so better to give money back to shareholders. It is worth it to invest in companies that are poor capital allocators? 

More generally, whether it is distributed as dividends or reinvested in the business, the cash is there. If many companies can invest it in their business at their return on equity (mostly 10%+), does it make sense to withdraw it unless you need it? Even so, outright sales are typically more tax-efficient.

Mea Culpa - HLSS, OCN, ASPS

If it wasn't clear already, I was wrong, very wrong on Erbey's mortgage servicing companies. The analysis can go on for pages, but the key is this: Erbey's companies relied on cutting corners on costs to make their competitive advantage. As a result, they deliver an inferior product (mortgage servicing) that matters to both consumers & regulators.The MSR transfers etc. that were part of the original thesis does not work if they cannot service mortgages effectively.

Buffett once said:

When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.

In this case, I'm actually not sure if management is that skilled. Anyone can cut costs by partially ignoring the rules of the industry. Then, ASPS took on debt to buy back shares & 30x+ ttm p/e.

I actually feel like it is value-trap now, though have no position in the shares after selling them mid-year 2014.

Correlated Commodities - Part 1: E&P

Given the cheapness of the refining companies, I've tried my hardest to justify the purchase of PSX/MPC. The result has been a further refutation of my long thesis and the reverse thesis. Companies which produce crude oil and its products (e.g. gasoline) are actually in the same situation as iron ore & steel producers. Very lean times are approaching.

Let's invert and try to justify the purchase of oil producers. Most exploration & production (E&P) oil companies in the usa have grown due to the development of "tight oil" reserves. These reserves (e.g. e.g. Bakken Shale, Eagle Ford) have become viable due to the development of techniques such as hydraulic fracturing & horizontal drilling. These techniques, which have now become widespread in the United States, have led to thousands of new drilling sites and large increases in production:

Source: http://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=MCRFPUS2&f=A

Great - looks like the potential revenue is there. However, what about cost? Looking at fast growers such as CLR, we see that growth requires very high capital expenditures. In fact, CLR's free cash flow has been negative for the past four years. As a result, we can say that the growth in CLR has been essentially debt-financed. Now, it is possible that investments in tight oil require large upfront contributions which taper off, but that is not the case for fracturing, where continued production requires continued capex.

Okay, so may be E&Ps as a whole may just be break-even and not make "excess" profits. If crude oil prices rise, couldn't they make more money? In the short term, sure, but how easy is it for others to look for new wells? In short, it takes less than a month from start to production, so barriers to entry is easy for those with capital. Capital in no short supply given high levels debt issuances for energy producers. As a result, competition is high and always waiting in the wings to drive down prices quickly, similarly to gas shale. This is makes investing in E&P's a tough business, at the very least.

This is just the beginning, however. E&P's may do okay with flat to rising oil prices near $100, so what would drive a panic-driven sell-off of both futures & equities? One possible answer, which I'll dig into will be in part 2.


Disclosure: short CLR & other oil E&P company equities

"The lady doth protest too much, methinks"

After coming across this article about investors losing $1 billion+ by investing money through "secureinvestments.com", I was reminded of this quote: 

"The lady doth protest too much, methinks" -  Hamlet by William Shakespeare

The key takeaway from this quote is that the more loudly we hear an assertion, the more likely it is not so genuine. More concisely, the loudest person in the room usually has the least to say. When a business names itself "Secure Investments," one should be especially wary of how secure it is.

Now, this is very unfortunate for those affected and I do hope they are able to get some of their money back. However, it is worth noting some rules of thumb which can help investors avoid landmines such as the above:

1) Education about investments is the best protection one can pay for. Learn from many sources to see different viewpoints. For example, just reading about Buffett's annual performance of 20%+ would make a 300%+ annual return with principal guarantee sound like a fairy tale. If this company is so good, why doesn't it just trade its own money?

2) When it comes to investing money, there is virtually nothing without risk. Guarantees are only worth the honesty and business making the guarantee. More fundamentally, just calling a product guaranteed doesn't make the underling asset (in this case, currencies) any less risky.

3) There is no substitute for effect due diligence when evaluating investments or managers. The ironic thing about the examples in that article are that many investors distrusted brokers but ultimately lost it all to a business they trusted. Many read statements/web profiles from Secure Investments but didn't verify or see with third-parties about the validity of such statements.

There are many more, but the consistent theme here is that like most things, there are no shortcuts.

Synchrony Financial

Synchrony Financial (NYSE: SYF) is General Electric's former retail finance arm and presents an interesting opportunity to invest in banking/lending and private label credit cards. What first got me interested is its cheap valuation (<10 times ttm earnings) and high returns on equity/assets (30%+/3%). As a bank these are fantastic metrics, though leverage is normal.

But how is this as a business? SYF is a bank which uses its deposits/capital to lend to consumers often through private label credit cards. These are the Home Depot credit cards, etc. which are often pitched in checkout lines. The benefit to consumers are discounts (up to 5%) at that particular chain, while companies get another tool to offer brand loyalty and promotions. It is this last aspect which is useful for companies and may indeed give it some pricing power. As the largest private label credit card issuer by market share (40%+) it may indeed be the go to source for private label credit. It can therefore focus more on relationships than pricing.

However, the relatively high rates and typically lower-class clientele on consumer side may be difficult. In particular, there may be a saturation point for such credit cards because such cards are more useful at larger/diverse retailers such as Amazon.

This may indeed be one of the larger risks for SYF. Lending, while muted, is highly profitable now because lower overall interest rates are suppressing defaults and the danger is that the credit cycle is a peak. I believe this is less likely given the lack of lending overall by banks (i.e. monetary velocity) such that only the top borrowers are getting credit. SYF survived the last crisis while remaining profitable (per their prospectus), so at ~ 10 times earnings this looks to be a good price for a decent business.

Disclosure: Long SYF

Asset Allocation does Not Solve the Funding Gap

Many pension funds/endowments and many other defined-benefit plans are behind their benchmarks. 2013 helped greatly, though it was only in 2012 that funds where in big trouble. Basically, they have promised a certain amount of future payouts but their current funds are not enough to do so. Part of this reason is the Federal Reserve's QE and other rate-lowering methods. Plans can plan on 5% return from their treasury bond portfolios, but with 10-yr treasuries yielding less than 3% they fall short.

To solve this problem, investors have shifted out into the risk-curve, buying assets/funds with fewer guarantees at only marginally better yields. Is this the right call?

To answer, let's ask this: if buying higher yielding assets gets better results, why were funds just buying now? Why were they not buying in 2009/2010 when yields were substantially higher?

One answer: it's the incentives. Buying a higher yield now gives the possibility of hitting the target while pulling back guarantees under-performance. Liquidity/Fed and price-stability gives the illusion that all is good so that managers can do so. We already know the results of this; a similar bid occurred from 2001-2008 with CDOs and other yield-oriented instruments. We see that now in anything related to fixed income from MLPs (oil/gas etc.), mortgage reits, high yield bonds and of course alternative investments.

(Source: http://dealbook.nytimes.com/2014/08/14/the-signals-from-the-high-yield-bond-market/?_php=true&_type=blogs&_r=0)

The result? So far, pensions are better but it's despite their asset allocations. In the previous link, Rhode Island pension funds allocated to alternatives only to see vanilla equities outperform.

My point is that allocations should be driven by opportunities in the market, not trying to beat the benchmark every year. Just because the plan needs 5% returns does not mean one should choose the best-performing assets or those which yield the most. Investing is investing, that is, putting capital where the risk is (far) justified by the reward. Hedge funds/alternatives, bonds, equities should be judged on whether the manager/asset is priced relative to the risks they take. For example, right now activist hedge funds have been doing extremely well. Does this mean endowments should allocate more? Not unless they can get the top managers and lower-than-average fees.

Now, measuring risk/reward is a tough topic, to say the least. However, that should be the base for allocations. Using "alternatives" to "diversify" because the manager is scared of another 2008 is not. Investing in an equity manager/index when equities are cheap relative to norms; that is better.