June in Macau, Or Why Gambling Stocks Can Be So Maddening

June in Macau, Or Why Gambling Stocks Can Be So Maddening
Courtesy of mgmmacau.com

One of the most important numbers for Macau-facing stocks is typically the monthly revenue figures – and the estimates compiled leading up to those announcements. With market share on the island largely well-defined, investors look to the overall growth numbers to get a sense of the future earnings potential of Macau’s casinos, and, thus, their correct share prices.

Fears that overall growth on the island will slow have been cropping up for some time, with many observers predicting a so-called “hard landing” in China that will result in severe economic difficulty for that country and for the high rollers that remain the key source of revenue in Macau. Just last summer, Macau-facing stocks took a significant hit as monthly and yearly growth estimates were cut repeatedly. The stocks would bottom in early August after the Macau government announced year-over-year growth of just 1.5 percent in July, numbers better suited to the anemic US land-based industry rather than the world’s largest, and fastest-growing, gambling market. By the time the slide had ended, shares of Macau casino operators had fallen 25-40 percent in a span of just three months. Some stocks – notably Las Vegas Sands (LVS) – still haven’t regained their peaks from the spring of 2012, despite the fact that the broad market has gained nearly 20 percent over the same time period.

As such, executives and investors in Macau must have been thrilled by news that came out in the middle of June. According to Barron’s, on June 17th, RBC Capital Markets analyst John Kempf wrote a note in which he estimated that gambling revenues had risen 39 percent from the week prior. Kempf raised his monthly growth estimates sharply; in the next two days, analysts from Citigroup, Oppenheimer, and Wells Fargo, among others, would follow suit. As Barron’s pointed out, Kempf’s note alone appeared to boost Macau stocks; US-listed operators LVS, Melco Crown Entertainment (MPEL), MGM Resorts International (MGM), and Wynn Resorts (WYNN) all rose 2-3 percent in trading that day, getting another boost in early action on the 18th.

Interestingly enough, when June numbers were reported last week, revenue growth actually came in above even most of the raised estimates, with year-over-year growth reaching 21.1 percent. Year-to-date, Macau gambling revenue has risen 15.3 percent over 2012, a growth rate actually slightly higher than that seen a year ago. And at the time, with the June estimates raised, and fears of a slowdown in Macau seemingly kept at bay, shares of operators in the enclave seemed set to rise.

They didn’t. In fact, they collapsed. Over the next week, shares of the six publicly traded Macau operators fell between 9 and 14 percent, with long-time outperformer Galaxy Entertainment (0027.HK) seeing the largest decline. Literally billions of dollars in market value disappeared in the immediate wake of news that growth on the island was well ahead of expectations. Why?

The answer is US Federal Reserve Chairman Ben Bernanke. On June 19th, Bernanke appeared to signal an end to “quantitative easing,” a series of Fed programs (including massive purchases of US government bonds) designed to keep interest rates low and (whether intentionally or not) asset prices high. Lower interest rates decrease the cost of debt, making funding for large-scale (and job-creating) projects, mortgages, and other loans cheaper and more available; they also lessen the attractiveness of saving, notably through the purchase of government bonds. (Amazingly, even after a substantial rise in bond yields – or interest – in the days after Bernanke’s speech, you can give the US government $1,000  for three years. In return, you will receive just $7.70 – seven dollars and seventy cents! – in interest payments each year, with your $1,000 returned at the end of the period, presumably worth less due to the ravages of inflation. And, by the way, you will pay federal income tax on the $7.70 as well.)

QE, as quantitative easing is called, has been a boon for markets of all types. Notably, the substantially lower interest rate offered by sovereign debt in the US (and Japan) has allowed for the so-called “carry trade,” in which large investors borrow heavily at low interest rates and put the capital to work in riskier, higher-returning assets such as real estate or casino stocks. With rates rising as the Fed slows its purchases of bonds, the carry trade becomes less profitable, hedge funds need to sell, and the specter of a round of falling prices, leading to more sales, and even lower prices, raises its ugly head.

The fear of a Fed slowdown and a subsequent devaluation of risk assets led the market to plunge in the wake of Bernanke’s comments; but beyond the 19th, the market held up rather well. In the same week Macau stocks plunged by an average of 10 or 11 percent, the US and Asian markets (excluding Japan) fell just 2 to 3 percent. (Chinese stocks saw a sharper fall, though they still outperformed their counterparts on Macau.)

The action seen in these three days in June shows the maddening nature of investing in the gambling industry. As I wrote nearly a year ago, economic sentiment retains an outsized impact on gambling stocks. Despite the fact that Macau is well-positioned for continued growth, and despite the fact that the broad market is holding up well, Macau stocks (excluding MGM) are still well down from their prices before the good news about June was projected, and then confirmed this past week. This is a not a near-term issue, either; only Galaxy and Melco Crown have outperformed the US broad market over the past two years. (To be fair, over the same time period only Wynn has underperformed the Chinese market, and only modestly, as Chinese stocks have suffered from some of the same economic worries mentioned above.)

At the end of day, investors – and executives – in the gambling industry remain largely at the whim of global economic performance and sentiment. No matter how well-run a casino, the very nature of the business model makes it nearly impossible to maintain earnings in the face of an economic slump. As such, the volatile nature of gambling stocks stems from the fact that they are largely leveraged plays on economic fundamentals. When times are good – see 2006-07 in Las Vegas, which led to massive projects such as CityCenter and the stalled Echelon development from Boyd Gaming (BYD) – casino stocks outperform. (In 2007, MGM traded near $100 at its peak, relative to $15 per share today; shares of BYD are still down by three-quarters from their levels back then.) When times are bad – or even when investors begin to fear that times might turn bad – they underperform. The decline of Macau-facing stocks over the last couple of weeks is just another example of that difficult reality.

It’s problematic for the average investor to tease out these economic effects. I’ve covered the use of “pairs trades” as one way to hedge against economic uncertainty, with the most profitable trade over the past few years being long the Macau subsidiaries of US-listed companies (such as Wynn Macau (WYNMF.PK) and Sands China (SCHYY.PK)) and short the US parent companies. Investors can also pair Macau stocks against Chinese stocks in general by short selling Chinese index funds such as the SPDR China (GXC) and buying an equal dollar amount of Macau operators.

The catch to these strategies is that, while limiting downside, they also limit an investor’s ability to profit if stocks take off. And with yet another short-term pullback in Macau, it seems simply smarter to just directly buy shares on the island. With mass market growth continuing, and with operators adding mall, entertainment, and retail revenue, there is still plenty of room for growth in Macau. Competition is likely to come from other Asian countries, but so, potentially, are new gamblers as their economies grow at a rate far ahead of that of nearly any Western country. All told, Macau remains a potentially lucrative opportunity for its casino operators and investors in those companies. But those investors need to be aware of the risks posed, not just from the businesses themselves but from economic fears the world over.