Description

DESCRIPTION AND INVESTMENT CASE

Emperor Entertainment is the only Hong Kong listed small-cap (~US$335m market cap) Macau casino operator, all the other 5 being large caps with market caps ranging US$ 9 - 37bn. The company is a subsidiary of the Emperor Group, controlled by Albert Yeung, one of Hong Kong' most prominent tycoons and a Forbes dollar billionaire. The company 60%-owns and runs the Grand Emperor casino and hotel complex in the heart of downtown Macau (www.grandemperor.com). The remaining 40% belongs 20% to SJM (Macau's former casino monopoly, now one of Macau's six casino license holders, along with Galaxy, Melco, and the Macau subsidiaries of Wynn, Sands, and MGM), 15% to Francis Choi (another prominent Hong Kong tycoon and dollar billionaire), and 5% to world-famous actor Jackie Chan. Mr Choi and Mr Chan are both personal acquaintances of Mr Yeung. The Grand Emperor is a  small "boutique" casino, well attended by movie and music stars, partially because within its premises it hosts what is arguably the best nightclub in town, and because the Emperor group also controls (among several other things) an established movie and music label in Hong Kong. The property was inaugurated in Jan 2006, spans over 23 storey and over 60k square meters and features 77 gaming tables (63 mass-market and 14 VIP), >300 slot machines, ~300 hotel rooms, business centre, some retail premises and other entertainment facilities (5 restaurants, gym/spa complex, nightclub etc).

Macau gaming is a growing industry, linked to the growth of upper-class China disposable income and consumption. Gaming revenues in Macau increased by over 13% in 2012. Despite the large base (Macau is already ~6x larger than Las Vegas in gaming revenue terms), consensus still points to high single digit to double digit growth for the next several years, based on the view that most Chinese love playing, incomes are growing double-digit, and that to date only a fraction of China population has ever visited Macau.

Emperor' gaming revenues and clean earnings increased by 40% and 60% y/y respectively in FY12, i.e. Apr 2011 to Mar 2012 (the company adopts a March y/e financial year), and by 12% and 26% respectively in H1 FY13 (Apr to Sep 2012).  Thanks to two key competitive advantages, i.e. higher reliance on high-margin mass-market and captive VIP junket operations, despite its smaller size Emperor manages to generate margins even higher than any of the top 6 much larger Macau casino operators (5 listed in Hong Kong: SJM, Sands China, Wynn Macau, MGM China, Galaxy; one, Melco Crown, listed in the US). As the property is new and maintenance capex limited, around 2/3 to 3/4 of EBITDA converts into free cash flow, and returns on capital are close to 40%, which has allowed the company to quickly repay all development loans and build a cash pile that covers over 40% of the company's current market cap. Based on reasonably conservative assumptions (gaming revenues down 4% y/y in H2 FY13, due to the very large base, but up again 11% in FY14) the stock is trading on 5.6x P/E and 1.9x EV/EBITDA on FY14e (to March 2014) numbers, and >6% dividend yield despite the low payout (35-40%, calculated on clean earnings, ex gains on fair value changes in  investment properties). This results in a discount of 62% on P/E and 83% on EV/EBITDA to the average of the five large cap HK-listed Macau casino peers.  Crucially, all the weakness in Macau gaming revenues over the past year or so has been limited to the VIP segment (i.e. big ticket players, so called "high rollers"), while the massmarket keeps growing double-digit. SJM, the former monopolist which remains the industry leader in terms of market share, has recently guided for ~25% industry growth for the massmarket segment in 2013, while the VIP segment is only expected to grow around mid single digit. Emperor derives ~3/4 of its gaming revenues from massmarket (77% to be precise, as per H1 FY13), thus it's uniquely positioned in the current environment (for large cap peers the mix tends to be 2/3 VIP and 1/3 massmarket), which everything else being equal would justify a hefty valuation premium to peers.

At the currently depressed share price, Emperor' free float is worth less than $130m. However, liquidity alone cannot justify such a wide valuation discount. So why is the stock so cheap? There are primarily three reasons in our view.

Consensus view is that smaller casinos cannot compete and are all bound to succumb. Consensus is patently wrong in our view, as proven by Emperor' superior economic performance over the years: higher margins, higher returns and free cash flow generation, and yet still growing nicely. In reality Emperor, and a few other small Macau casinos, have cut themselves an attractive niche, either by targeting the mass-market and/or targeting VIP players who prefer a cosier and more familiar environment, where for instance one doesn't have to walk for miles from the table before reaching a toilette. Having said that, some of these smaller casinos lack such niche focus and, being "stuck in the middle", are indeed struggling. In fact, this represents an M&A/consolidation opportunity for Emperor, which is piling up cash to one day (sometime over the next 12-18 months in our view) acquire and then restructure one of these struggling small Macau casinos, or to build a second casino from scratch (an acquisition is far more likely in our view).

License risk. Another reason why the stock is so cheap is the license risk: unlike the large cap operators, Emperor does not hold a gaming license in its own right, but "leases" it from SJM, along with 13 other so-called "satellite" casinos of SJM. However, although in theory SJM may one day withdraw the license to more profitably use it in-house, in reality this is a long-standing practice that nobody has any intention to challenge, including SJM, as these 14 casinos make up about a fifth of the industry in revenue terms and employ a lot of people (Emperor alone ~1,000, which out of a total employment population in Macau of ~360k means something) who would otherwise lose their jobs, resulting in some 3%-4% increase in Macau unemployment rate. Only once SJM has ever claimed tables back from any of its satellite casinos. Specifically, in August last year the satellite casino Greek Mythology agreed to transfer 40 tables to SJM' flagship Grand Lisboa casino. However, this was a very unique situation, justified by the bitter ongoing dispute for control of the Mythology casino and hotel complex between founder Mr Ng Man Sun (a veteran junket operator) and his former lover Chen Meihuan, a dispute which culminated in Mr Ng being attacked with knives by a mob inside the casino, as a result of which the hotel was temporarily closed and visitor numbers to the casino dropped dramatically. Mr Ng agreed to transfer tables to SJM under the only condition that SJM would also takeover a proportional number of his employees (about 200), as the business had dropped so much that he could not even cover fixed costs, and in Macau gaming mass layoffs are just considered unacceptable. Mythology is still struggling and may yet return a few more tables to SJM in the future. Some of the other 14 satellite casinos are also struggling, as those are very old properties that keep losing market share. Hence some of those casinos may also one find convenient to return some tables to SJM. However, in its recent analysts' calls SJM repeatedly warned analysts and investors not to read too much into the Mythology event, stating that at the moment no satellite casino (including Mythology) is planning to return any more tables to SJM, clearly hinting that the decision has to be consensual. SJM would anyway struggle to utilize any additional table that may be returned from the satellites, as the floorspace in all SJM Macau properties is already utilized to the limit, thus in order to squeeze in more gaming tables other entertainment facilities (restaurants etc) may have to be sacrificed, which goes against the current trend in Macau gaming of offering more non-gaming entertainment to entice the massmarket.

Most crucially, there's no chance at all that Emperor may return tables to SJM, as Emperor is a virtually brandnew property (opened 2006), and it has always performed strongly, generating margins well in excess of any of SJM' casinos. Besides, SJM is also a shareholder in the Grand Emperor casino with a 20% stake, and SJM' patron Stanley Ho is a long-time acquaintance of Mr Yeung, to the point that Mr Ho's daughter used to date Mr Yeung' son.

Last but not least, even if the license were to be withdrawn overnight (something unconceivable in our view), the 60k square meters property, which sits in a prime location in downtown Macau, could be redeveloped in residential and/or commercial, and should fetch at least $350m-$400m value (very conservatively assuming $6-7k/sqm), which added to the cash pile (~US$ 140m net cash attributable to the company, ex minorities, as per March '13e) implies an upside to the current market cap (US$ 335m) of 50%-60%, i.e. even under the worst case (no case in our view) scenario that the business were to be discontinued overnight.

Mr Yeung controversial personal reputation. This is the third reason why the stock is cheap. Through the property company Emperor Intl (also listed in HK), Mr Yeung controls >60% of Emperor Ent. Despite being a high profile HK tycoon and a Forbes dollar billionaire, Mr Yeung has often been accused in press articles and internet posts to have links to organized crime. Whilst such links are unproven (Mr Yeung was found guilty of perverting the course of justice in the late 1970s, illegal bookmaking in 1986 and insider trading in 1998,  but he was never convicted for any more serious crime; he also recently sued Google for defamatory links to his name), one has to understand that virtually all Macau casinos depend on so-called "junket" operators to bring in, lend money to (and make sure they eventually return it) the VIP players from mainland China, to the point where typically the junkets earn a higher share than the casino itself on every VIP dollar gaming revenue. The reputation of such junket operators is often controversial. Mr Yeung used to run his own junket operations in Macau. In fact, the Emperor casino originates from Mr Yeung' one-time junket operations at SJM Grand Lisboa, which were subsequently transferred to the Emperor casino as soon as it opened. Incidentally, Mr Yeung' one-time junket operations represent a great benefit to the company, as Emperor doesn't need to rely much on any external junket operator, which contributes (along with its mass-market focus) to the higher profit margin vs. peers. The massmarket focus and minimal reliance on junkets also result in a major de-risking of the business model, as VIP operations tend to be more volatile, and also more exposed to the lumpy risk of China government regulation/intervention. Incidentally, over the past few days fresh rumours have re-emerged (they come and go) that authorities are planning to launch a crackdown on Macau junket operators in six big Chinese cities, as part of an anti-corruption campaign led by president-in-waiting Xi Jinping. It's important to emphasize that any such crackdown would have very limited repercussions on Emperor, unlike for any of the six license holders, all heavily relying on third-party junkets.

But for investors, the real question is: does Mr Yeung have any intention to hurt minorities, and even if he wanted to, what could he possibly do? In fact, digging into history we could not find any obvious instance of Mr Yeung taking advantage of minority shareholders. In late 2010, he actually restructured Emperor Ent., hiving off some property assets from the company and turning it into a pure casino play, and launched a bid for the balance, in a transparent transaction which was welcomed by the market (the stock rallied in the aftermath and the delisting attempt eventually failed). But even if he wanted to hurt minorities, what could he possibly do? Cooking the books and transferring profits out can be safely ruled out, as Macau gaming is a regulated industry, and Macau government supports itself through gaming taxes (40% of gross gaming revenues go straight into the government' pockets in the form of duties). Admittedly, there's a risk that the company's significant cash hoard may be invested in an acquisition or new venture deemed to be value destructive by the market. However, as the stock sits on less than 6x P/E, clearly the market is not attaching any value to the cash (which sits in the bank and currently earns close nil), thus we would see virtually any use of the cash as a positive for the stock. Additionally, since the delisting exercise failed in early 2011, Mr Yeung (through the holding company Emperor Intl) has modestly increased his stake (from 58.5% to 62.5%) through transparent open market purchases, always regularly filed for disclosure with the HK exchange. Last but not least, although the dividend policy may be considered somewhat ungenerous (historically 35%-40% payout on clean earnings, low in order to accumulate cash for expansion, i.e. acquire/build a second casino), dividends have always been paid since bank covenants allowed, and consistently increased by 15%-20% per annum.  

All considered, we believe that the stock is cheap for the wrong reasons. The idea that all small Macau casinos are bound to die is patently wrong, with Emperor' >6-year long success story clearly contradicting it; quite simply, there are good and bad small casinos, and Emperor is definitely an excellent one. The license risk is also more perceived than real; truth is, it's just never going to happen to Emperor. And whatever one may think of Mr Yeung, his business connections have actually been a great benefit to the company, which has always treated minority investors fairly. Notwithstanding the lower liquidity, we believe the company deserves to trade at least on 6x EV/EBITDA (vs. the 9x - 14x range where large cap peers are trading), which applied to our reasonably conservative FY14e forecasts implies a fair value per share of ~HKD 4, suggesting ~100% upside to current share price.

FINANCIALS AND VALUATION

Our full financial model (P&L, BS, CF, gaming revenue model, peer comparison) is available on request. We assume gaming revenues to drop 4% in H2 FY13 (Oct '12 - Mar '13), due to the very challenging comps (gaming revenues increased 44% y/y in H2 FY12). However, we expect gaming revenue growth to resume in FY14 (12 months to March 2014), pencilling in  11% growth in the full year, which we believe is conservative given Emperor's oversized massmarket exposure (current expectations for overall Macau massmarket segment growth for calendar year 2013 range 15% to 30%). We project the group' EBITDA margin to remain broadly stable at around 46% (46.6% in H1 FY13), underpinned by the increasing shift in mix in favour of the higher-margin massmarket segment. In FY10-11-12 the company managed to turn some 70%-80% of EBITDA into free cash flow, due to very modest working capital and capex requirements (the property is quite new), and low tax rate, which refers exclusively to the hotel operations (for gaming operations in Macau the bulk of the tax burden is actually on gaming revenues, where a 40% tax duty is levied; Emperor reports gaming revenues net of duty). For FY13e we project cash conversion and ROACE to remain broadly stable at around 80% and 40% respectively. It's worth highlighting that in our "clean" earnings calculation we strip out any gain/loss on fair value change in investment properties, i.e. the retail premises within the complex which are leased out to third parties, which is non-cash and non-recurring in nature; since Macau real estate prices have significantly increased in recent years, our restated "clean" earnings are somewhat lower than the company's reported earnings; we calculate the P/E on these lower, cleaned up earnings. Referring to the EV calculation, it's worth noticing that we only subtract the net cash that is attributable to the company, since some of the cash is actually parked in the operating casino company, which is only 60%-owned. By the same token, the EV/EBITDA (and EV/EBIT as per table above) is calculated by dividing the EV by only the portion of EBITDA (or EBIT) that is attributable to the company, after accounting for minorities. Last but not least, in the EV calculation we conservatively do not subtract the value of the investment properties (book value as of Mar '12: US$ 57m), and we also do not account for some other smaller assets held that do not even show up in the books but have meaningful liquidation value (one amusing example: in keeping with Macau grand luxury style, the hotel lobby is laden with 78 bars of 999.9 fine pure gold, each weighing 1kg, worth at today's gold price some US$5m; the book value of this is zero, fully depreciated furniture).

Regarding the valuation multiples comparison with the large cap peers, it is worth highlighting that the large cap peers all have a December financial y/e, while Emperor has a March financial y/e. For the sake of simplicity, and since perfect calendarization is impossible for most Hong Kong listed company as reporting is not quarterly but semi-annual, we compare Emperor' FY13-14e (i.e. 12 months to March 2013-14) numbers with the large cap peers' CY12-13e (i.e. 12 months to Dec 2012-13e) numbers. Emperor manages to generate an EBITDA margin that is over 2x as large as the average of the large cap peers (as per 2013: 46% vs 22% - please notice that SJM' low margin is biased downward by the fact that it reports gaming revenues gross of tax duty, and that a lot of its revenues come from the satellite casinos where it only makes 4%-5% margin in the form of the license fee), despite its far smaller size and despite having to take a 4%-5% cut on gaming revenues to pay for the SJM license fee (the five large cap peers don't need to pay any license fee as they are all license holders). As discussed, the primary reason for such higher margin is that Emperor is disproportionately exposed to the mass-market segment, which is typically more profitable than the VIP segment, because in VIP the majority of gaming revenues are actually collected by third-party "junket operators".

Catalyst