News Analysis date published New: 
Monday, June 25, 2012 - 14:30
New Date created: 
Monday, June 25, 2012 - 14:30
New Date last updated: 
Monday, June 25, 2012 - 14:30

After a 300% Surge, This Chinese Gaming Stock Could Double Again

Monday, June 25, 2012 2:30 PM

It's no secret the Chinese economy is slowing. A multi-decade boom has perhaps given way to a new phase of more moderate growth. Still, we're talking about what is likely to be the fastest-growing major economy in the world. Here in the United States, we'd be thrilled to post the 5% annual gross domestic product growth that China is likely to generate during the rest of this decade.

And with this solid growth comes a rising middle class, more millionaires and more billionaires who will have more disposable income, leading to a tidal wave of consumer spending.

So how can U.S. investors profit from this growth?

My favorite way is the island protectorate of Macau and its group of casinos. These gaming venues are a virtual magnet for China's wealthy. My favorite gaming operator in Macau: Melco Crown Entertainment (Nasdaq: MPEL).

Shares of Melco rose roughly 300% after I recommended the stock in September 2010. After shares were hit by profit-taking early this year, I suggested investors again revisit this dynamic growth story.

The stock made a nice upward move again this past spring. But if you missed this opportunity on those past occasions, then you've just been given another chance. Shares have been sucked down in this challenging market, and by my math, could have 100% upside if you have a 2-3-year time horizon.

A solid take rate
Management has developed a strong record for maintaining a tight lid on expenses, even as the company has undergone a rapid expansion. That's helped EBITDA margins rise from 9% in 2008 to a recent 20%. Recent results have also been solid. Melco has topped earnings per share (EPS) estimates by at least 25% in each of the last two quarters.

A growth lull ahead?
Shares may be pulling back in the face of a possible slowdown in the Macau gaming sector. Revenue for all of the casinos grew just 7% from a year earlier in May, which is a sharp comedown from the 20%-plus year-over-year growth rates seen in recent months.

In a June 19 note to clients, Merrill Lynch trimmed 2012 EPS forecasts for this company from $0.86 to $0.83. Yet they figure shares are still quite inexpensive, trading for just six times enterprise value on a 2012 EBITDA basis. That's well below the peer group average of 8.1, according to Merrill. The firm sees upside for the whole group, especially Melco, for which it has a $20 price target.

That's a sentiment you'll hear from other analysts as well. Analysts at Citigroup also note the low EBITDA multiple and consider Melco a "top pick," with a $22 price target. Analysts at Goldman Sachs have a more modest price target of $18 (which still represents 50% upside).

A catalyst in place
Not only is this stock fairly inexpensive, but we may be just days away from a news item that could boost shares. By the end of June, Melco hopes to get the green light from the Macau government to start building Macau Studio City (MSC), which I discussed in January. As I noted back then, "the casino will be located right next to the Lotus Bridge immigration station, making it the first and most visible casino on 'the strip.'" If and when the company gets the official nod, then shares could score get a quick 5% or 10% gain. Approval would also lead analysts to likely upgrade their earnings forecasts for 2015 and beyond, when MSC comes on line.

Risks to Consider: If the Chinese economy slumps really badly, then year-over-year gaming traffic trends in Macau may turn negative, pushing this stock below $10.

Action to Take --> Rising levels of wealth and a cultural proclivity for gaming makes this one of the best "China plays" out there. Shares may be choppy in the near-term, the MSC catalyst notwithstanding, but look poised to make new highs in the next few years as the company's slate of casinos becomes fully operational.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.