Scientific Game

Passing the Buffett Test

New research from CLSA suggests that even WarrenBuffett, the ultra-safe “Sage of Omaha,” would score Macauhighly on his well-known investment checklist.

Wednesday, 19 December 2012 18:10
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After years of explosive growth, Macau’s gaming sector is on the cusp of a major transformation from which it will emerge as a solid yield play. Given gaming’s high-risk reputation, we are concerned that conservative investors may miss out on what we see as a ‘Raining cash’ opportunity. Indeed, our analysis suggests that even Warren Buffett, the ultra-safe ‘Sage of Omaha,’ would score Macau highly on his well-known investment checklist.

Macau scores eight out of 10 on our Buffett-inspired scorecard, which draws on his key investment criteria. The gaming enclave has a straightforward business model with wide economic moats, excellent earnings visibility, high ROEs, robust balance sheets, disciplined capital management, strong free cashflow generation and generous dividends. The sector also has a wide margin of safety on valuations, trading on a dividend of 5% relative to the market’s 3%.

As detailed in our recent “Still raining cash” report, we believe the Macau gaming sector is the best way to gain exposure to the rising Chinese middle class. In light of slower top-line growth, we would own the sector for dividend yield and the gradual pricing in of Cotai projects.

1. Investment criteria

Is the business simple and understandable?

Just as Buffett favors simple and understandable businesses, so do we. Macau gaming companies are straightforward with around two-thirds of earnings derived from casino, hotel and retail operations. VIP is less transparent and accounts for twothirds of revenue, but only one-third of the industry Ebitda.

Casino operations

Each casino game entails a different house advantage, with the average advantage for baccarat of 1.24%, blackjack of 2%, single-zero roulette of 2.7%, craps of 1.0% and Caribbean Stud of 5.47%. The casino theoretical win depends not only on the house advantage but also the player’s average bet size and average length of stay. So it is critical for the casino to keep the players playing.

Outcomes at the gaming tables could be volatile and thus it is important for casinos to manage volatility, which could be done in three major ways:

By increasing overall business volume. Based on the “law of large numbers”, as the number of bets per hand at any given level wager increases, the actual outcome will move closer to the expected outcome.

Reduce risk exposure. Casinos can limit their risk exposure by setting a maximum betting limit, which forces more hands to be played at any given bankroll.

Shifting or sharing risk. Revenue-share arrangements with Macau junket operators (at predetermined percentages of 40-45%) versus a rolling program can also reduce earnings volatility. The casinos have a fairly simple cost structure:

• The gaming tax is the largest component at 39% of the gross gaming revenue. This is very high relative to other markets (e.g., Singapore at 16-17%, Las Vegas at 7%) and we do not see a high risk of the tax increasing.

• The second-largest cost component is the junket commission, which is 40-45% of the gross VIP revenue (not mass market revenue). There is agreed maximum commission cap of 1.25% and therefore we do not expect this to increase.

• Other operating expenses include staff costs, utilities, advertising and promotion costs. The mass market generates margins of about 40% while VIP is around 10% due the inclusion of junket commissions.

Hotel operations

Hotel operations are simple, with the company charging a fee for hotel-room usage. With the strong inflow of visitors into Macau, hotel operators have enjoyed high hotel occupancy of more than 90% and have been able to charge high hotel room rates of US$200-300 per night.

Retail operations

Some of the major Macau casinos such as Wynn Macau, Four Seasons Macao, Venetian Macao and City of Dreams have large retail shopping areas in their integrated resorts. The retail segment generates revenue by charging the tenants fixed rent or turnover based rent. In 2011, Sands China’s retail properties generated HK$12 billion in retail sales and HK$1.3 billion in rental income, which is largely in line with what Times Square, a premium shopping mall in Hong Kong, generates.

VIP and other elements Junkets assume a key role in Macau’s VIP gaming operations. The key reason for the existence of the junkets is the China central government’s currency restrictions, limiting currency movement into and out of the country. Owing to the restrictions, most VIP players rely on junket credit to fund their gaming expenditure. China also lacks a robust credit database, prohibiting casinos from directly extending credit to players and thus creating opportunities for the junkets.

Some perceive Macau as a place for corrupt government officials to launder money. But over the past decade, no gaming company has been prosecuted for any crimes or violating the anti-money laundering control procedures. In fact, some of the world’s most prestigious financial institutions have been charged with greater and more frequent financial crimes than the global gaming companies.

Over the past 10 years, the number of criminal offences in Macau has remained low. In 2011, 12,500 crimes were recorded, representing a crime rate of only 2.5%, which is lower than all major US cities and significantly lower than the 4% in Las Vegas.

2. Is there an economic moat protecting the business?

Macau gaming operators are protected by a strong moat, with only six gaming licenses issued there. We understand that the government has no intention of issuing additional permits, which installs a strong entry barrier. The government’s determination to tame table supply growth and to slow the pace of new project approval are also key factors in driving gaming companies’ strong earnings and cashflows. The government has implemented a table cap of 5,500 tables to March 2013 and will allow about 3-5% growth thereafter with around 2,000 additional tables by the end of 2022.

Further, Macau casino operators do not face much external competition. Over the next decade, Macau and Singapore will remain the only two major gaming destinations in the region, serving billions of Asian gamers. Japan could be the next meaningful market but will most likely serve the local population (see our ‘Asia’s wonderland’ report). Meanwhile, it is unlikely that the Chinese government will legalize gaming anywhere within the country, including island destinations such as Hainan. While Hong Kong would be an enormous market, we believe the probability of casinos being licensed there is less than 1%.

3. Is management candid with shareholders?

With a long-term investment horizon, Buffett favors companies that are candid with shareholders. In Macau’s gaming industry, analysts and investors generally enjoy excellent access to CEOs and other senior management over a period of time. Companies tend to host regular conference calls, attend investor conferences, host property tours and have strong investor relations teams.

Financial disclosure is world-class in Macau, especially compared to some other Asian gaming companies such as Genting Singapore, which is weak on disclosure.

4. Does the business have a long track record of earnings growth?

Buffett prefers companies with a long track record of delivering earnings growth. The Macau casino operators do not score well in this area, as most only have five years of operating history. US operators, such as Wynn Resorts and Las Vegas Sands, have a longer operating track record, but their earnings, historically, have been volatile due to high gearing levels during the financial crisis. This is unlikely to be repeated in the Macau gaming sector, with many companies in a net-cash position.

We expect Macau to deliver more consistent earnings growth as VIP gaming revenue moderates on a high base. With a slowing VIP segment, we are also seeing increased earnings exposure to the more robust mass-market segment, which will help lower gaming companies’ earnings volatility.

5. Does the business have a consistent operating history?

Buffett dislikes companies that expand beyond their comfort zone and favors those with a consistent operating history. We note that the Macau gaming operators have, over past years, been very focused on their expertise, which is to develop gaming properties in Macau or in Asia. This is not true for others, such as the Genting Group in Malaysia, which have been very aggressive in other industries and other markets.

6. High ‘owner earnings’ and lack of need to reinvest

Buffett places significant emphasis on cashflow-generating capability and regards it as the best metric to evaluate the quality of the company. He favors firms that generate high ‘owner earnings’, also known as free cashflow. We share the same view and have been bullish on Macau gaming because of its strong free cashflow-generating capability. We were the first broker to discuss this theme in our ‘Raining cash’ report in September 2011. We expect the sector to deliver US$3-4 billion of free cashflow in 2012-14, representing 4-5% FCF yield.

Buffett places huge emphasis on cash earnings generated by companies and gives preference to those where minimal capex is required to maintain competency. Comparing the Macau gaming sector with other sectors in Asia, the capex-to-sales ratio is very low, allowing most of the earnings to flow back to company shareholders.

For casino properties that have been completed, maintenance capex required is also minimal. Not until recently have we seen a slight uptick in maintenance capex with high capacity utilization and slightly intensifying competition. But relative to the Ebitda generated by the casino property, maintenance capex required is still minimal.

Looking forward to the next round of projects, the capex requirement will not be too onerous. Macau’s gaming companies plan to spend US$2.0-3.5 billion on their next Cotai projects, which looks like a huge figure on the surface. But the capex spend will span three to four years, implying that the average annual capex on a new project is around US$0.5-1.0 billion. Companies also normally fund 50-75% of the Cotai expansion by debt financing, which implies the actual cashflow strain to the company would be even less.

7. Rational with managing capital

Buffett praises companies which return excess cash to investors. Macau gaming operators score well in this aspect as they return cash generously to investors by means of dividends. In 2011, SJM, MGM China, Wynn Macau and Sands China maintained a dividend payout ratio of 80- 100%, representing US$3 billion of dividends returned to shareholders.

8. Generates high return on equity

As a value investor, Buffett likes companies that generate high ROE. The Macau gaming sector scores well on this front, with its low capex requirement allowing high ROE. In 2012, we expect the Macau gaming sector to generate 33% ROE, which is the highest among all the sectors in Asia.

The high return on equity of the Macau gaming sector has been underpinned by the respectable investment return generated by Macau casinos. In 2012, we expect these casinos to generate an investment return of 30-130%.

9. Avoids excess debt

Buffett prefers a prudent management style and would favor companies that avoid excess debt. The Macau gaming sector is highly rich in cash. By 2012, we expect the sector to have a net debt/(cash) as a share of equity ratio of 1%, with three out of the six Macau gaming operators in a net-cash position.

However, the situation only changed recently, with some concerns of bankruptcy particularly at the US parent company level only a few years ago. Las Vegas Sands was badly hit during the financial crisis. In 2008-09, the company had just opened The Venetian Macao and Four Seasons Macao, while SandsCotai Central and Marina Bay Sands still remained under construction. The earnings base of the company was much smaller then, while net gearing was sky high at 300% in 2007 as project loans were yet to be repaid. With the low income base and the high interest cost, LVS recorded two consecutive years of net losses in 2008-09. The share price of Las Vegas Sands was down 97% from the peak and there were worries about the company going bankrupt.

10. Current valuation offers margin of safety

Buffett also stresses the importance of a margin of safety, which is the discount to fair value that the stock is currently offering. We understand the importance of having a margin of safety and we do not rate a stock a ‘BUY’ unless we see more than 20% upside to our fair-value estimate of the stock.

Warren Buffett defines fair value as the discounted value of the cash that can be taken out of a business during its remaining life. That is different from our sum-of-theparts’ valuation methodology, in which we value the existing operations on EV/ Ebitda and add an additional option value for the upcoming Cotai project. Historically, EV/Ebitda is used because the gaming companies incur a large amount of preopening cost, non-cash cost (depreciation and amortization) and interest cost which resulted in a low net profit figure. That is no longer true, with most of the casino properties fully ramped up and companies generating strong net profits.

We value the Macau gaming companies based on 10-15x EV/Ebitda. We give preference to stocks that have: short-term earnings growth; higher exposure to more defensive mass-market and non-gaming segments; a Cotai or other growth story; and pay dividends. We score the six Macau operators on these metrics, with Sands China earning 14 ticks, Wynn Macau 11 and SJM 11.

Even if we were to abide to free cashflows and dividends that Warren Buffett pays most focus to, Macau is still undervalued with their expected free cashflow yield at 4-5% in 2012-13 (versus Asia consumer of 2-3%) and dividend yield at 4-5% (versus Asia consumer of 3%).

If we were to apply a discounted cashflow (DCF) valuation to the Macau gaming companies, we still see them as attractively valued. We apply conservative cashflow growth estimate of 5% per annumto forecast the free-cashflow generation of the existing properties operated by the gaming companies. We also apply a 10%WACC [weighted average cost of capital] and a terminal growth rate of 2% to derive the fair value of the existing casino properties.

At current share prices, the Macau gaming operators are still trading at a 15-63% discount to the fair value of their existing properties, not to mention that there is still upside potential to the company’s fair value as the upcoming Cotai project starts operation. We believe the valuations of the Macau gaming companies are still attractive at current levels and offer investors a reasonable margin of safety.

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