The Best Stock to own for the “Las Vegas of China” has 50% Upside

While taking time out on a trip to Hong Kong a few years ago, I took a ferry over to the island protectorate of Macau. The place felt like a ghost town, with few tourists, though the locals said that would soon change. They were right. A few years later, Macau has finished up the first phase of a building boom that has made it the “Las Vegas of Asia.”

Indeed, Macau has quickly emerged as one of the top vacation destinations for Chinese citizens, which is why I thought Melco Crown Entertainment (Nasdaq: MPEL) would make a great investment. I profiled this up-and-coming casino operator more than a year ago, and its shares subsequently zoomed from around $4.50 in the fall of 2010 to around $16 this past summer — a gain of 255%.

Investors went on to lock in profits on this highflying stock, but with shares back below $10, it’s now a bargain once again. In a few years time, this stock could hit that 52-week high again as investors start to understand the wild card this company has up its sleeve.

A building track record
The strong stock price performance I mentioned earlier has a straightforward explanation. Melco Crown has built a pair of impressive casinos — City of Dreams and Cubic — which have steadily drawn rising crowds. These casinos attract what’s known as a “mass premium” crowd, which spends more money than rank-and-file tourists that arrive on junkets, but are not quite as mercurial in their spending as the VIP crowd.

Melco sought out a differentiated strategy that many doubted would succeed. The strategy entailed Vegas-style entertainment such as a Cirque-du-Soleil-style theatrical production and a club-like dance hall with a DJ. Conventional wisdom held that such amenities would be lost on Chinese tourists that simply want to gamble. Those amenities aren’t deriving extra profits, but they are driving solid foot traffic.

The financial results for Melco explain why this stock zoomed from under $5 to above $15 in a fairly short time: Melco likely generated 40% sales growth in 2011, to $3.75 billion. And after a modest loss in 2010, it likely earned around $0.50 a share in 2011.

Yet the real reason to own this stock is because of an event that won’t happen until 2015.

Macau Studio City
Melco Crown acquired a 60% interest in Macau Studio City in June 2011, which is shaping up to be the premier gaming spot in Macau when it opens in three years, thanks to its location. The casino will be located right next to the Lotus Bridge immigration station, making it the first and most visible casino on “the strip.” That section is relatively quiet now, but should be much more active thanks to current infrastructure development in the area. The 32-acre site is also expected to be a stop on a soon-to-be-built light rail system.

 By all accounts, Melco’s $360 million purchase price for that 60% stake was a great deal. The fact that Melco already had a contract in place to manage the facility enabled the company to negotiate much more favorable terms than rivals would have secured. Yet the deal spooked investors, who quickly realized it would take roughly $1.7 billion to develop the facility, which might lead Melco Crown to sell a lot of stock to raise cash. Those fears of dilution were heightened further when the company announced plans to dual-list its shares in Hong Kong. That’s often a precursor to capital-raising.

In response, management has had to hold a series of meetings with the investment community. Their main takeaway: Melco will need to spend hundreds of millions, not $1 billion or more, to develop Macau Studio City. And with roughly $1 billion cash in the bank, the company will not be selling any more stock. The development will strictly be funded out of cash and ongoing cash flow.

Of course, Macau Studio City will eventually see competition on that part of the strip, but not for a while. Along with joint venture partner Lai Sun Group, Melco has already secured many of the needed government approvals for the project, which has already been prepped with $200 million in site development as land has been cleared and utility cables laid down. Other casinos that have yet to be announced in the area wouldn’t open before 2017 or 2018 — at the earliest.

Risks to Consider: The Chinese economy may temporarily slow in coming quarters, leading to reduced discretionary consumer spending. That could cause the stock to weaken further as year-over-year revenue comparisons in Macau start to cool. Still, such a pullback would make this stock even more appealing in light of Melco Crown’s bright growth prospects.

Action to Take –> Macau’s impressive growth looks set to continue. A 90-mile high-speed train will connect the Gaungzhou region of China with Zhuhai, which is roughly 20 miles from downtown Macau. That railway line, slated for completion in late 2012, along with an expansion in the hours of operation for key border crossings, “should increase the number of mass-market visits to Macau from mass-market tourists from China,” according to Daiwa Securities. With three major casinos in operation by 2015, Melco Crown Entertainment stands as the best pure play for Macau’s burgeoning gaming scene.

From a current $10, shares could hit $15 — or more — once this business model ripens. At maturity, Melco Crown is capable of around $700 million in annual operating profits. Shares should trade up to 12 times EBITDA once investors again understand the high-growth and high margins built into this business model. Assuming a multiple of 12 on that operating profit figure, this company could eventually be valued above $8 billion, well above the current $5.3 billion market value, implying upside of 50% or more.