We are about to get some answers on the future of the Macau casino industry with the imminent opening of Phase II of Galaxy casino on Cotai.
For nearly a year now, Macau gaming revenues have declined at an accelerating pace that has defied the attempts by investors and analysts to explain them away as a crack down on corruption.
The drop in Chinese visitation and the persistent, all-fronts regulatory moves—smoking bans, talk of visitation caps, labor pressures from unions and the government, the incessant talk about diversifying away from gaming, delays in casino approvals, delays in infrastructure improvements—suggest something more than cleansing Macau of corrupt government officials gambling public dollars away.
A recent report out of the University of Macau suggests another, more fundamental and more plausible explanation: The Chinese government doesn’t want to see the concentration of capital in the pockets of foreigners.
In this case, by foreigners you can read Americans, with whom China has an increasingly contentious competition, and Hong Kong billionaires who represent the one-country two-systems agreement that the national government seems to want to slowly suffocate.
Galaxy II could be an important test, both of the depth of the market and the intentions of the Macau and Chinese governments.
If Galaxy II grows the market, that will buttress the bullish argument that Macau is supply driven, and that the five mega resorts to follow will add to the prosperity of the casino companies.
If it cannibalizes, the bears might be proven right, and the big declines in stock prices of recent months might be followed by a round of severe downward revaluations.
Morgan Stanley analyst Praveen Choudhary recently issued a cautionary report that fits the concerns we have long expressed. Essentially, he sees four points of concern:
• Demand. The recent decline in Chinese visitation and in hotel occupancy hits hard at the theory that China is an under penetrated market. The half-dozen new casinos opening in Cotai will dilute EBITDA and earnings per share in their first 12 months.
• Regulations. A visitation cap, full smoking ban and whatever stricter rules would accompany concession renewals are not in earnings estimates and valuations.
• Return on investment is falling and estimates of higher margins are hard to justify as Macau transitions from a gambling-centric to a middle class entertainment destination.
• Valuation. Stocks are selling at 15 times enterprise value to EBITDA and could fall to 10.
Other difficulties exist. Jamie Zhou of Macquarie notes that casino operators have limited cost cutting flexibility. Labor accounts for 60 percent to 70 percent of costs but can’t be reduced by layoffs, which the Macau government frowns upon, and unions are pushing for 5 percent wage increases to offset high inflation, Zhou said.
And, despite all the bad news out of Macau, Zhou thinks policy risks are still underappreciated, citing continual plugging of loopholes that allow gamblers to take more than $3,000 in cash out of China.
The Galaxy II opening will be followed in the third quarter by Melco Crown’s Studio City.
Thus, in a few days we’ll get an inkling of the future. And by year-end, we should know most of the story.
