The last few months and particularly the last few weeks have particularly interesting for my style of investing. Fears on a China government crackdown/reforms have spread from technology majors, education, gaming, ride-sharing, live-streaming, music to pharmaceuticals, entertainment, alcohol and now property and Macau gaming. If you believe the media, almost everything in China is uninvestable.
Despite our contrarian investment philosophy, we don't buy indiscriminately every time there is a sell-off. We have avoided buying majority of the aforementioned sectors simply because we couldn't analyze the risks, we didn't see the value or we didn't like the business.
For example, in the case of Evergrande, we looked at the company all the way back in 2014 and formed the view that it was manipulating its book by using investment property accounting to revalue its development assets - instead of reporting assets at cost, it marked to market assets using DCF on THEIR OWN FORECAST future realizable value. In one case, it valued a 'luxury development' using DCF which hadn't even received zoning approval! This wildly overstated book was then loaded up with leverage to buy more land, start business ventures (EV company, bottled water...) and random assets like a soccer team, etc. This is truly the Enron of China on steroids. Needless to say investing in any part of its corporate structure is a crapshoot - a pure bet that the Chinese government will bailout investors.
Similarly but for less exciting fundamental reasons we did not find value in education, music, gaming, ride-sharing, local services, pharmaceuticals and property companies even after their fall from grace. Many of these companies had looked sexy in the past but their business sustainability was always questionable e.g. not paying social security or min wage to gig-economy workers was never going to be acceptable anywhere in the world, forever upward trending traffic figures, etc. We didn't like paying high prices for growth in the past and we don't know where their new normal is today.
The exception to the above sold off list is the Macau gaming stocks. These companies fell -30-40% last week after the Macau government started the 45 day gaming license renewal consultation. Sands China and Wynn Macau stock prices were the worst hit and fell to 50% of their 2020 and ~33% of their pre-covid levels. Sands China's stock price is now back to 2010 levels when Macau's gross gaming revenues (GGR) was only 60% of today and before they'd even built their Sands Cotai (now called The Londoner Macau) and Parisian casino complexes.
Nothing material was announced last week but the market had suddenly become fearful that Macau gaming will become the next target of Chinese government reforms. Specifically, fears on:
Increased government scrutiny and control: 1) tighter control over AML practices and junkets which will negatively affect VIP customers, 2) restricting the casinos' ability to return capital, 3) forcing them to make social contributions
Loss of casino license: especially"non-domestic" companies like Sands and Wynn
Changes to the gaming tax rate
Decreasing the duration of casino licenses
While changes are likely to be made e.g. decreased license period to 10yrs, tighter control over money laundering and greater role of casinos in Macau's development, we don't believe the Macau casino operators' values have become permanently impaired. Our observations are:
Tightening AML practices is nothing new and VIP GGR has been declining constantly since 2013. In 2019 VIP GGR was ~55% of 2013 levels and contributed ~43% of total Macau GGR. However at the same time premium mass market has been growing and alongside it non-gaming revenues. Hotel capacity has been tight and occupancy for 3-5star hotels has been >80% since 2011 (with 90s% in 2018 and 2019)
The Macau economy is highly dependent on the gaming industry. In 2019 86% (MOP104bn) of Macau's tax revenues came directly from casinos and their impact on the local economy is far more than this. Annual Macau government spending is ~MOP85bn
Casinos have long been active donors to social programs in Macau and supported government policy directives e.g. Heqin. They've been seen as good corporate citizens such as keeping their workforce intact during covid and driving vaccinations
Macau's gaming tax is the highest in the world at around 35% of GGR and another 4-5% which casinos pay for social developments - the risk of the take rate increasing further is low
Macau's integration and development is an important part of the long term Greater Bay Area plans
There is no viable alternatives to Macau for Chinese premium tourists. Singapore is probably the closest quality asset, while others in Korea, Cambodia, Philippines are lower quality. Australia, US and Europe are too distant, even in a re-opening scenario. Also the government has been clear in its policy that it prefers Chinese consumers to spend at home rather than abroad and Macau and HK are both beneficiaries of integration
It makes little sense for the Macau government to shoot the golden goose and even less sense for China to 'punish' an example of positive integration with Mainland. Furthermore, the fragility of the covid situation has made it less likely Macau will enact controversial policies or increase the demands on the casino operators.
The risk of licenses being withheld from majority foreign owned operators seems minimal. There is no economic rational for such a move and the only reason would be to send a loud and hostile message that all foreign interests and investments are not welcome. Despite what western media may say, this flies directly in the face of China's current moves to open the domestic economy to foreign players (e.g. finance, automotive industries, tech), attracting foreign capital and confidence to domestic assets and slowly allowing controlled investment capital outflows (the Wealth Management Connect program started this year and all the various stock connects). The long term objectives of RMB globalisation, China trade dominance, attracting foreign talent, capital and technology are unchanged. Why upend decades of careful strategic planning and positioning over a couple of casino licenses?
From a risk/reward framework perspective, if one was to buy all six operators today:
Using Macau's 2019 GGR (similar to 2017-2019 average GGR): you're paying roughly high single digit PE and a similar EV/EBIT multiple. Given the operators have mostly completed their latest capex cycle of new resorts and upgrades, depreciation will be greater than their capex for the next few years so earnings is understated vs cashflows and the free cashflow yield is around low to mid double digits
Assuming 30% fall in 2019 GGR and -25% decline in margin: you pay roughly high double digits to 20x PE (similar on EV/EBIT basis) and get mid single digit free cash flow yield
The later scenario is extreme and assumes VIP GGR falling to just MOP50bn (2007 levels) which actually should be positive for margins given higher profitability from premium-mass customers.
Put together, a payoff range based on buying all the operators seems to be: -25% on the downside (Macau operators trade at mid teens multiples) and 2x on the upside (back to historical valuations and international peer multiples). Based on our qualitative assessment, the win/loss odds is much better than 50/50 and the expected value using these numbers is high.
One can tweak the payoff structure further by eliminating Galaxy Entertainment from the mix (which enjoys a significant premium vs its peers). We've gone one step further by only buying only Sands China and Wynn Macau in a 2:1 ratio at a full position within the portfolio. The payoff range is probably more like -50% and 3x but with very little change to the odds so our expected EV is much higher. In terms of trade execution, we've chosen to buy 80% of the position today and wait for supportive technicals and/or material fundamental news to buy the remaining 20%. From a portfolio perspective these Macau exposures also give some welcome non-systematic risk diversification.
We're optimistic Macau will stage a recovery over the next few years and that these investments will work out. But as our Pershing Square Tontine (PSTH) experience has humbly reminded us
https://www.investin1.com/post/spac-vs-sparc-the-ackman-difference, even when you get the analysis correct (Universal Music Group was up 30% from the listing price), you'll still get run over occasionally by the fat tail bus. But that's the nature of investing and exchanging risk for rewards.
Our portfolio continues to be heavily long China fears. We own great companies at great prices and prefer this risk exposure over getting caught out in a deflating asset bubble.
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