BUSINESS

Macau’s Uncertain, Rosy Future

TAGs: Caesars Entertainment, Editorial, Galaxy Entertainment Group, investing the hard way, las vegas sands, Macau, McDonalds, Melco Crown Entertainment, sands china, SJM Holdings, Vince Martin, Wynn Resorts

People crave certainty. Some of us may handle uncertainty better than others, but, for the most part, we want to know where we stand, and what we should expect. It’s why “risk” is a word with an often negative connotation; taking a risk is often perceived as a dangerous thing, sometimes solely because it leads to an uncertain, unknown outcome. 

Investing The Hard Way: Macau's Uncertain, Rosy FutureThat desire for certainty, however, is detrimental, and even fatal, in investing. Indeed, for decades now, Wall Street has used smarter and smarter people, and larger and larger computers, to create ever more complicated models to value stocks, bonds, and asset-backed securities and manage risk with a degree of mathematical precision and certainty. So far, the only things the models have noticeably improved is the time it takes before they eventually blow up, most notably in the 2007-08 worldwide financial crisis. 

Models need data, which is why there are entire departments of securities analysts at investment firms around the world, devoted to analyzing companies and projecting future sales, cash flows, market shares and the like. And while their efforts are detailed, and often impressively accurate, their projections are constrained by one of the basic facts of life: shit happens. 

And that’s OK. Investors, like gamblers, don’t have to be right all of the time, or even most of the time. They simply need to be right more than they are wrong and have the flexibility to admit to and correct their errors. At the same time, patience is required, to let investment ideas play out and to accept that we simply do not – and will never – know where a stock is headed. 

Few sectors of the investment world have better shown the often-ludicrous desire for certainty better than shares of the gambling giants with operations in Macau. Data points are constantly compiled and analyzed and debated; everyone seems to want to know where exactly Macau is headed. Part of the reason for this is the perceived riskiness of investments on the island. On its face, an investment in Las Vegas Sands (LVS) or Wynn Resorts International (WYNN) – let alone their Asian competitors such as Galaxy Entertainment (GXYEY.PK) and SJM Holdings (SJMHF.PK) – seems to be a high-risk investment. After all, these companies are required to create billions of dollars in infrastructure and spend billions more annually in operating expenses, with their potential profit contingent almost solely on a relatively small base of high net worth, high-stakes gamblers. The ruling government is a one-party, nominally Communist, system with a slowly diminishing, but still ever-present bent toward censorship and repression. Owning shares of a Macau casino would seem to present a far more uncertain future than, say, investing in McDonald’s (MCD) or a grocery store chain. 

These risks – and the fears associated with them – are reflected in the trading movements of Macau-facing stocks. Based on beta – a measure of volatility relative to the rest of the market – LVS is more than three times as volatile as the average stock, while WYNN and Melco Crown Entertainment (MPEL) see their shares move more than twice as much on a relative basis. This volatility is often seen in sharp moves on small pieces of news, such as monthly revenue figures or quarterly earnings reports.

This is not to say that those data points are immaterial or even insignificant; but, on their own, their value can easily be overstated. Lower monthly revenue figures can be caused by immigration issues, or, given the island’s reliance on high-stakes baccarat players, even bad luck in the form of lower-than-expected “hold.” Hold can also affect quarterly earnings reports, as can the movement of holidays, or the absence – or presence – of a few high rollers. Yet each monthly or quarterly release seems to create a new batch of speculation about whether Macau is “maturing” or “slowing down” or “rebounding” or about to fall into the sea. 

It’s not just financial figures; witness the report earlier this month that authorities in Beijing were planning “a crackdown” on junket operators in Macau. Share prices across the sector skidded as investors feared, apparently, that government pressure on the junket operators might spook high-rollers and hurt gambling win on the island. Similar fears had dogged stocks in December, when speculation about the island’s then-pending smoking ban effect on mass market gamblers drove share prices down. 

The fears are understandable, if the reaction to them a bit overstated. There are risks in Macau, ranging from potential regional competition elsewhere in Asia to a slowdown of the mainland economy to the highly competitive fight for market share in the enclave. But there are risks everywhere in the market; higher beef prices can be just as painful for McDonald’s as a smoking ban might be for the Sands Cotai. Just because cattle futures markets are far less viscerally scary than the mention of triads and Chinese Communists doesn’t make those financial risks any less real.     

But the potential rewards offered in Macau simply dwarf those found almost anywhere else in the world, and that’s what investors need to focus on. Many investors have focused on the risks, and missed out on buying LVS for less than $2 per share in 2009, or even $32 per share at its bottom last summer. (The stock closed Friday at $52.90). Caesars Entertainment (CZR) passed on Macau in 2006 for similar reasons; the explanation given by CEO Gary Loveman for his “worst decision” he has made is revealing. “The quantification on Macau took me in the opposite direction [of entering the market],” he told Bloomberg in an interview. “You had to have a kind of intuitive courage.” 

Right now, that “intuitive courage” should take precedence over discussions about monthly growth and what they mean for Wall Street operators. And truth be told, the Macau story shouldn’t take that much courage at all. What Macau operators have is a monopoly in the world’s most populated country, with the fastest-growing cohort of millionaires, and a seeming cultural bent toward gambling. The island’s resorts have barely begun to penetrate the higher-margin mass market gambling segment, while the convention and retail businesses have the potential to add additional earnings growth. Both the mainland and Macau governments, while nominally Communist, have been as ruthlessly capitalist as any government partners could be; beyond continuing demands for  diversification of the island’s economy – which may, in the long run, benefit Macau operators by providing more stable sources of recurring revenue from retail and lodging – the Chinese have clearly helped drive, rather than restrict, growth on the island. 

It’s that partnership which belies the fears of the so-called “crackdown” and other government intervention. In Macau, everyone is getting what they want. The island has unemployment around 2 percent, lowering crime and no doubt satisfying local bureaucrats. The mainland government can use the island as an outlet for VIPs who want to gamble, while also continuing strict prohibitions elsewhere in the country and online. The casino owners are raking in cash – Sands China alone generated $1.9 billion in free cash flow in 2012, according to its annual report – and the high-rollers are happily playing baccarat. 

That’s not to say that this story will end happily, or that there won’t be political, economic, or competitive challenges on the island. Such thinking would be foolish. Macau will change; but that’s not necessarily a bad thing. After all, the Las Vegas of 1965 – or even 1995 – hardly resembles the Vegas of today, in a myriad of ways. But the overall story in Macau is still thrilling, still exciting, and still vastly profitable. It’s more important than single data points or unfounded fears about the Chinese government. And it’s not ending any time soon, because the principals involved are all benefiting – and profiting – from the island and its business. 

Investors need to keep this in mind whenever analysts announce their new projections for annual growth rates or earnings per share at Macau operators. Those analysts are guessing just like the rest of us; they may have more data, and their guesses may be more educated, but they remain just as uncertain as the rest of us. Certainty in the market is an illusion; in Macau, even more so. But Macau remains a better bet than anywhere else in the gambling world, and most places beyond it as well. 

 

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