The Hot Stock in the New Mecca of Gambling

Talk about great timing. Major casino operators decided a decade ago to build massive new casinos in Macau, just a stone’s throw from Hong Kong and mainland China. Those new gambling halls are now packed to the gills, thanks to the region’s ever-rising tide of freshly-minted millionaires.

Meanwhile, traffic at casinos in Las Vegas, Atlantic City, Biloxi and elsewhere in the United States remains in a funk. The fact that shares of Las Vegas Sands (NYSE: LVS) and Wynn Resorts (Nasdaq: WYNN) are up +110% and +50% year-to-date, respectively, is solely due to their exposure to Macau. U.S.-focused Casino operators like Isle of Capri (Nasdaq: ISLE) can only look on with envy. That firm announced very tepid quarterly results August 31st, pushing shares down -14%.

If you think you missed the Macau surge, fret not. There is a way to play the region with a stock that is only starting to find appreciation among investors.

#-ad_banner-#Building boom
After years of construction, new casinos have been opening at a frenzied pace during the past few years in Macau. Industry revenue rose more than +50% last year and are rising +50% again this year. Lest they kill the golden goose, regulators have installed a moratorium on new development until 2013, so industry volumes are likely to rise +10% to +15% next year and in 2012 as a few more casinos still under construction open their doors.

Casinos generally must be open for a few years before they can build a loyal following and operate at peak profit levels. Las Vegas and Wynn were among the first to establish a foothold, and their Macau casinos have recently produced stellar profit results, which fully accounts for those heady share price gains posted this year.

Meanwhile, Melco Crown Entertainment (Nasdaq: MPEL), which was a few years behind the curve, is still tweaking operations. Quarterly profits have been erratic, especially this past winter when an unexpected bout of gamblers’ good luck led to a profit shortfall. Shares took a beating, from above $7 last September, falling to nearly $3.

Yet shares have started rebounding, rising +15% in the past five trading sessions to around $4.60. The improving sentiment comes from industry chatter that the company had a stellar August and is boosting market share in Macau.

According to a recent report from analysts at Sterne Agee, Melco has moved past Wynn Resorts into a tie with Las Vegas Sands in terms of traffic. That’s led the analysts to conclude that Melco is on track to surpass consensus sales and profit forecasts for 2010. That would be a nice turnaround, as the company has a history of underperforming relative to expectations.

Monthly Market Share of Macau Gaming Revenue 2010

Macau’s casino operators have eschewed the Las Vegas model which has always sought a mix of gambling and entertainment. “Zaia,” a musical production put on by the Venetian Macau was largely considered to be a failure. But with scant entertainment options, Melco still thinks that some tourists will still be ready to pony up for a glitzy show. So the company has produced “House of Dancing Water,” which is thought to be better geared toward Chinese tastes. Early reviews have been positive, which may explain some of the recent market share shift.

Action to Take –> Despite the recent rebound, shares of Melco still trade at a discount to peers. While Las Vegas Sands and Wynn Resorts trade for about 12 times projected 2011 EBITDA on an enterprise value basis, Melco trades for just nine times projected 2011 EBITDA. Closing that gap yields a +30% upside for the shares.

More importantly, unless you assume that the fast-growing Chinese middle class will start to shrink in the face of an economic contraction, Melco could prove to be a solid long-term holding. The company is controlled by the son of legendary Hong Kong investor Stanley Ho, and he has stated plans to make sure that Melco continually seeks out new revenue and profit streams in the world’s newest gambling mecca.