Description

Thesis

We expect MLCO’s earnings to exceed pre-Covid levels in 2023 and for the business to subsequently see steady growth (with cyclicality) from this point. In a year, this more normalized level of profitability should be in view, and at 15x 2023 sustaining FCF per share, MLCO will trade at $26 (145% upside).

Currently, three key risks are weighing on the valuation, a wave of government crackdowns on various industries including elements of Macau gambling, Covid re-opening delays, and re-licencing. Each of these risks should lessen in importance over the coming year and act as a catalyst for the shares. 

The crackdown on Macau gambling is front and center today and represents a low probability, high impact existential risk for Melco, but we do not think that the government will drive the Macau companies out of business for many reasons, including the Macau reliance on the gambling infrastructure for nearly 100% of their budget. 

Summary

Macau integrated resorts are a large majority of the earnings for MLCO. After adjusting for their 55% ownership level of Studio City and the need to pay partners almost 40% of EBITDA in their Manila asset, Macau accounted for 87% of 2019 EBITDA and their flagship City of Dreams resort (CoD) is 66% of the total.

The 39m visitors to Macau in 2019 were primarily from Mainland China (71% of visits) and HK (19%). This converts to gaming revenues through either the VIP channel (high rollers who receive rebates/money back based on their volume of gambling, often managed/financed by ‘junkets’) or mass gaming (more standard gaming, generally without a formal rebate agreement, covers a wide range including the relatively high end ‘premium mass’ segment). 

Since 2013, due to government intervention, VIP gaming has greatly reduced in importance to the top line, and especially, the bottom line for Macau operators. Historically, it is thought that VIP gaming has been used to circumnavigate Chinese capital/currency controls. This behaviour is less prevalent since the corruption crackdown in 2013-16, where VIP revenues fell over 50% from peak and were still 40%+ lower in 2019. Remaining VIP revenues are still of low quality as they are competed for via promoters (junkets) who own the customer relationships. This results in low margins despite controls on the rebates that can be paid. Since 2019 the government has further clamped down on the operations of junkets, hurting their ability to lend/collect debts within the Mainland. As a result, VIP revenues are unlikely to recover towards 2019 levels, although there may be some benefits from these players converting to either more profitable direct VIP relationships with the casinos or to premium mass. VIP is relatively unimportant for MLCO as it’s a small minority of EBITDA: MLCO stated that in 2019 less than 10% of their Macau EBITDA could be apportioned to VIP (although we are cautious that the operating leverage from declines in VIP does have a larger impact than this statistic would indicate).

In contrast, mass gaming has been a sustained growth area for Macau consistent with the broader economic development of the Chinese upper-middle class and improved visitor numbers to Macau (easier visas, improving transportation links and more hotel rooms). Pre-Covid there has been only one notable down year for mass revenues, in 2015, at the height of the anti-corruption crackdown. Mass profitability is consistently high at Macau’s leading integrated resorts, c.40% EBITDA or 65%+ once striping out the revenue taxes. The inability to market directly in the Mainland likely improves stickiness and reduces marketing expense in the mass segment.

Significant constraints on supply (in addition to the large fixed costs) improves the quality of Melco’s business and avoids the aggressive competition that can accompany an oversupplied market with low variable costs:

• Macau is the only Chinese territory where casino gambling is permitted (no sign this will change).

• It is easier for Chinese nationals to visit Macau than other Asian gambling destinations, additionally the recent junket crackdown and continued Covid travel restrictions could accentuate this. Additionally, it is in the interest of China from the perspective of oversight (and financially) to keep gamblers in Chinese territory.

• The Macau government has consistently been under pressure from Beijing to slow the growth of gambling and Macau would also like to diversify its tourism offering. To this end they have restricted overall table number growth to 3% per year since 2013, put pressure on operators to build non-gambling space, and have generally not been granting additional land for casino resorts.

• In some similarity to the Las Vegas Strip, a specific area (Cotai) has been developing a network/clustering effect. It has contributed to making casino resorts elsewhere in Macau less profitable and relatively uneconomic for investment.

• 82% of MLCO’s ownership adjusted EBITDA is generated in CoD and Studio City, which are both well situated in this prime Cotai area.

Put together, leading Macau casinos (including wholly owned CoD and to a slightly lesser extent 55% owned Studio City) are high margin, FCF generating assets, which benefit over time from the growth of mass gaming in the context of constrained supply.

Risks

We are currently in the midst of a wave of Chinese government crackdowns on various aspects of capitalism/wealth/corruption, notable in the technology sector and for-profit K-12 tutoring. There is concern over the read across to gaming revenues in Macau. As discussed above, there has recently been a dramatic tightening on the ability of junkets to operate, impacting the trajectory of low profitability VIP business. Macau’s own recently released draft five year development plan puts further emphasis on reducing the scale of the VIP business. Our understanding from local experts and the operators is there has been and likely will be minimal impact on the premium end of the mass segment as attention is focused on the junkets’ operations rather than individual gamblers. Once the recovery is underway in 2022, this will clarify the impact of the current policies on gaming revenues and reduce regulatory concerns. It is also possible that the current wave of crackdowns will be somewhat relaxed following the consolidation of Xi’s power at the 2022 Party Congress.

A fulsome recovery has been continually delayed as a result of policies relating to China’s zero tolerance for Covid. Gaming revenues have been running below 40% of 2019 levels (slightly above breakeven EBITDA) due to an effectively closed border with HK (and the rest of the world) and a restrictive/manual process for granting visas to travel from Mainland China to Macau. It is unclear when one or both of these restrictions will be relaxed, however, with Chinese vaccination rates set to approach total coverage by the end of 2021 there will be increased pressure to find paths towards a relaxation of restrictions. By 2023, we expect China to largely normalize travel policies, most likely by living with Covid circulating through a vaccinated population. A reversion towards trend, alongside multi-year pent up demand, should allow for a strong recovery of industry mass gaming revenues to above 2019 levels (we assume 23% higher in 2023). Supporting the idea of latent demand, Las Vegas gambling revenues have reached new all time highs, as has Chinese luxury retail. Paired with some sustained cost savings, the mass recovery should allow for a greater level of profitability despite VIP revenues remaining very depressed. By late-2022 we expect to have visibility into reopening policy and a strong recovery for Macau.  

The six Macau operators have concessions/licences to operate which expire in June 2022, and uncertainty on the terms of re-licencing is an overhang on the shares. The process has been delayed due in part to Covid and it is likely that an extension of 1-3 years will be granted to the operators for a modest fee. Based on commentary/discussions with local experts and the companies we believe the most likely path is a relatively smooth renewal for MLCO with a large focus on capex commitments towards non-gaming development and no significant degradation in economic terms. The risk of non-renewal is especially low for MLCO as it is perceived to be a Chinese operator and has been a leader in non-gaming development (most recently Melco International Development, the holding company, has announced a partnership to develop a theme park/mixed use complex in neighbouring Guangdong). Macau could bring in another concession holder and eventually this would present some supply risk but only on a 5-10 year time scale. The recent news from Macau over licencing/regulatory issues has been substantively in line with industry expectations (with additional negative commentary on increased oversight and local ownership) but against the backdrop of the deadline approaching and the recent ‘anti-corruption’ wave, market concerns appear to be unduly elevated. Over the next 12 months, in addition to an extension, we expect increased clarity on the process, which should lessen concerns over left-tail risk to MLCO’s right to operate. More broadly, Macau gaming, in addition to being critical to the local economy, is a tool for the CCP to exert control and oversight on Chinese gambling, which would otherwise continue at a large scale abroad, and illegally on the mainland.

Chinese ADRs have been put under a negative spotlight in recent months and investors are concerned about delisting risk. The recent focus on the China side has been on other/newer industries and HK headquartered companies such as MLCO have so far faced less pressure from a US perspective. In a downside case, the listing could be moved to HK, where other operators have their main listing and do not trade at a discount because of this.

Despite the constrained geography of Macau/Cotai and tight regulation around new gaming space there are new supply additions which will impact the industry as it emerges from Covid, notably Galaxy Phase 3, SJM’s Grand Lisboa Palace, Sand’s Londoner development, and MLCO’s own Studio City Phase 2. This is a modest issue for MLCO given the overall pace of development is relatively low vs. history and the size of existing assets. Put together, supply as measured by hotel rooms in integrated resorts is likely to be c.15% greater in 2023 than 2019. Studio City phase 2 will also increase MLCO’s room count by 15% on a proportional ownership basis, however, these rooms will be on average less premium vs. the competitor additions. Given these supply additions, consensus expects MLCO to lose share in the recovery, but we think this may be over-stated given the continued strong performance of CoD following the Morpheous development. Currently MLCO has marginally gained Macau share since pre-Covid, although it is hard to read too much into these depressed statistics.

Management

Lawrence Ho (age c.45) has led and held a controlling stake in HK listed Melco International Development since 2001, which in turn now holds 56% of Melco. He is one of many children of Stanley Ho (who for 40 years operated a monopoly on Macau gambling). The start of Lawrence’s business career likely benefited from inherited wealth and contacts but his companies are said to have been run largely independently. In 2006, he partnered with Crown (Australian casino operator) in order to share in a Macau gambling concession and develop resorts. He was able to expand this joint venture (now MLCO) with little share count increase (+22%) since IPO in 2006, while also gaining control by using well-timed share buybacks and direct purchases by Melco International Development from Crown (who eventually decided to exit).

Lawrence Ho is primarily incentivized through his large personal ownership. Although there could be a conflict of interest between MLCO and the holding company, this has not been a negative in the past and MLCO has adopted broadly shareholder friendly policies with dividends and opportunistic share buybacks. Lawrence Ho’s track record of building value (i.e. Melco International Development’s volatile but high long term return), is paired with a willingness to take risks and experiment (e.g., a $75m star studded short film for the opening of Studio City which he later admitted was a mistake). Macau gambling expert, Desmond Lam, commented in his book that alongside good qualities he is also prone to “placing his bets every way with no clear strategy.” 

There has been concern in the past over distraction from the core Macau assets with investments in other geographies. This issue is lessened today since the sale of their stake in Crown Resorts and the cancelation of the Yokohama IR bid process. More generally, with the pressure from Covid, management has appeared to refocus on Macau.

Throughout the downturn Lawrence Ho has frequently used the share weakness to buy Melco International Development shares, most recently towards the end of July at HK$12.4.

Valuation

Adjusting for the minority interest in Studio City, we expect MLCO to generate $1.7 per share of FCF after sustaining capex (refurbishments and maintenance) in 2023. This assumes a strong recovery in industry mass revenues to 23% ahead of 2019 levels (MLCO’s resorts losing just c.5% share before the ramp of Studio City Phase 2) with industry VIP remaining 40% below. Our base case of $26 at a 15x FCF multiple accounts for long term growth of the now dominant mass segment, but also a discount from continued (lower) level of uncertainty over further crackdowns on high end gaming, and the risk around licence renewals. This valuation would also place MLCO in line with its EV/EBITDA trading history despite higher debt levels coming out of Covid (well termed out with ample liquidity). A moderate downside scenario of mass only recovering to 2019 levels, VIP down 50%, and 12x FCF would put the shares at $13 (still above the current price) and at the low end of the historical EV/EBITDA range.

Relative to the Macau peer group, we prefer MLCO for its lower valuation (even after accounting for potential supply driven share shifts) and low re-licencing risk as a Chinese company with a historical commitment to non-gaming development.

Catalyst

Reduction of the three overhanging risks detailed above (government crackdowns, reopening delays, and re-licencing) over the next year.