A Crown of thorns?
Recommendation
Steve Wynn, chief executive of Wynn Macau – which owns two casinos in the former Portuguese colony and is building a third – recently bemoaned that he 'can't predict the actions of a communist dictatorship'.
So he wouldn't have been shocked to hear from Li Gang, Beijing's point man in Macau, that the government is planning to take some – as yet unspecified – actions to improve Macau's economy. Coming on the heals of policies such as the corruption crackdown, visa and smoking restrictions, and limits on withdrawals from Unionpay debit cards – which have helped decimate Macau casinos' revenues over the past year – this would be a welcome development.
However, despite this surprising announcement, increasing concerns over the Chinese economy have battered the shares of any company connected to the country. Unsurprisingly, with Crown's 34%-owned subsidiary Melco Crown Entertainment heavily exposed to China via its casinos in Macau and The Philippines, its shares have fallen 13% since we upgraded it to Buy in April (see Betting on Crown, parts one and two). Is this a cause for concern?
Key Points
Melco biggest impact to Crown in medium term
Despite slowing Chinese economy, standard of living to keep rising
Downside more than balanced by opportunities
As noted in Betting on Crown – part one on 20 Apr 15 (Buy – $13.15), Crown's existing casinos in Melbourne and Perth are likely to show steady growth over the medium-to-long term, albeit with some ups and downs depending on the economic cycle.
And even if Melco Crown stops paying dividends, Crown's earnings before interest, tax, depreciation and amortisation (EBITDA) should remain above four times projected interest expense in coming years, meaning Crown's debt burden should be manageable.
So with Crown's new developments in Las Vegas and Sydney still years away, the travails of Melco Crown are likely to remain a major influence on Crown's shares over the short-to-medium term.
China crash?
The latest data from the Macau Gaming Inspection and Coordination Bureau (DICJ) suggest the decline in gross gaming revenue is slowing (see Chart 1). More importantly, given VIP (high-roller) revenues are unlikely to return to their former heights, signs that higher-margin mass-market revenue may have bottomed in the three months to 30 Sep 15 are encouraging. However, it's too early to draw firm conclusions and, in any case, we think it's more relevant to think about where Macau's economy might be in five or ten years' time.
As we noted in China crash: Are we there yet?, China's growth is slowing as it attempts to transition from a debt-fuelled, investment-led economy to one driven by consumption. This transition is proving difficult, with the country recently devaluing the yuan and also reducing interest rates and bank reserve requirements.
There's little doubt that Chinese economic growth will be slower in future, but it's similarly clear that the standard of living in China will continue to rise and that tens of millions more Chinese will enter the middle class.
As their wealth and disposable income increase, so will their desire and ability to travel outside their homeland. Even after decades of frantic economic growth, the Chinese still travel outside their country at much lower rates compared to more developed Asian countries such as Japan and Korea (see Chart 2).
Of the Chinese that do travel, Hong Kong attracts many more visitors than Macau due to its better shopping and leisure opportunities, additional hotel rooms and better transportation (see Chart 3).
As we explained in Betting on Crown – part one, however, the economic diversification of Macau and nearby Hengjin Island's economies into non-gambling businesses, along with significant increases in hotel rooms, should help narrow this gap. Meanwhile, improved infrastructure including additional rail access and a bridge connecting Macau to Hong Kong (reducing the trip to 50 minutes) will make it quicker and easier to visit Macau.
So, although Macau's VIP gambling revenue will probably never reach its former heights, the number of visitors and the money they spend in Macau's casinos should rise substantially over the next five to ten years.
Studio City tables
In the near term, however, Melco Crown's 60%-owned Studio City casino in Macau is due to open on 27 October, yet still hasn't received word on how many gaming tables it will be allowed to operate.
An allowance of fewer than 400 would jeopardise its projected returns and potentially lead to a default on its debt. While its lenders don't have recourse to Melco Crown, the board of Studio City recently retained advisors to help it deal with this possibility.
The company could transfer tables from its existing casinos such as City of Dreams but, as it wholly owns these casinos while only owning 60% of Studio City, this would dilute earnings.
Melco could get around this problem by purchasing the remaining 40% of Studio City from US investment funds Oaktree and Silver Point. The parent company has net cash of around US$400m and could afford the price tag of around US$1bn, even though its majority owned subsidiaries carry large amounts of debt as a result of City of Dreams Manilla only officially opening in January 2015 and Studio City not yet having opened. We've broken down the debt between the different entities in Table 1.
Melco Crown | Melco Crown (Philippines) | Studio City | |
Debt (US$m) | 1,559 | 605 | 2,121 |
Cash (US$m) | (1,985) | (166) | (853) |
Net debt / (cash) (US$m) | (426) | 439 | 1,268 |
Note: Figures at 30 Jun 15 |
Downside reasonable
Like Steve Wynn, we can't predict what the local chapter of the communist party will decide and so will have to await their decision.
If you haven't done so already, we suggest members re-read Betting on Crown – part two and note the various valuation scenarios discussed. Notwithstanding the situation in Macau, we still believe those scenarios capture the likely range of outcomes for Crown, and that the risks of investing in Crown are more than balanced by the potential rewards. BUY.
Note: Our Growth Portfolio owns shares in Crown.