Macau Casinos: Worth Gambling On?

The big bets that Las Vegas casino operators have placed on Macau have been drawing some unlucky cards. Macau is the world's largest gambling region and the only place in China where gambling is legal. Gross gaming revenue topped $44 billion in 2014, while Las Vegas pulled in $6.4 billion. The Macau gambling trade was, for 40 years, a monopoly run by Chinese billionaire Stanley Ho. Chinese regulators ended Ho's monopoly and opened the district to U.S. casino giants in 2002, with Wynn Resorts (WYNN) and MGM Resorts International (MGM) among those getting licenses to operate, followed by Las Vegas Sands (LVS). Hong Kong-based Melco Crown Entertainment (MPEL) — the old Macau Electric Lighting Co., a key player focused solely on the Macau market — is headed by Stanley Ho's son, Lawrence.

Wynn Resorts operates Wynn Macau and is currently constructing Wynn Palace, a $4.1 billion project on the Cotai Strip in Macau, expected to open in the first half of 2016.

Las Vegas Sands owns three properties in Macau through its majority-owned subsidiary Sands China. The company is currently spending $2.7 billion to build a fourth property, the 3,000-room Parisian Macau, expected to open in 2016.

MGM Resorts also holds a stake in a portfolio of Macau properties through MGM China. It plans to open a new property in Cotai in the fourth quarter of 2016.

With many billions of capital spending committed, the casinos group is heavily exposed to a possible slowdown in China's economy. Macau gaming revenue began to decline in June 2014 and has continued since then. In August, gross gaming revenue fell 35.5% from the year-ago period, a 15th straight month of declines. It fell 34.5% in July and 36% in June.

In addition to China's economic challenges, the fall-off in Macau gaming is attributed to the Chinese government's aggressive crackdown on money laundering and corruption, a smoking ban in Macau casinos and a reduction in visas issued. More recently, a plunging Chinese stock market and the devaluation of the Chinese yuan added more friction. About 70% of Macau visitors come from mainland China.

On Friday, Wynn Resorts stock traded near five-year lows and 70% below its March 2014 high.

"Macau continues to be more of a question mark than a certainty as we head through 2015 and toward our opening on March 25 of Wynn Palace in 2016," CEO Stephen Wynn said on July 29, when the company reported second-quarter earnings.

Among the problems facing Wynn is that it targets the upper premium VIP business and the top end of the mass market, a segment of high-roller gamblers on which China has focused its anti-graft policies. High-end players last year reportedly accounted for a majority of the $44 billion casino revenue in Macau.

This year, in June and July, it seemed that the worst of the Macau crackdown was ending. China government officials signaled a relaxation of visa norms and gave less stringent commentary on smoking bans in casinos. But that optimism deflated in late August when authorities raided district pawn shops, which authorities contend are a channel through which money launderers move ill-gotten cash from the mainland.

More Family-Friendly Gambling

In the second quarter, Wynn reported a 26% drop in revenue from the year-ago period, to $1 billion. It was the third quarter in a row of double-digit declines. The stumble was the result of a 36% net revenue decrease from its Macau operations, including a 41% drop in VIP table game turnover, versus a 6.2% decrease in net revenue from Las Vegas operations.

MGM's second-quarter earnings showed that total gaming revenue from Macau fell 37%, hurt by a 23% drop in table games on the main floor and a 43% drop in VIP table games revenue year over year.

But while China's actions have brought some bad luck to casino operators, the China government has also shown a desire to continue investing heavily in infrastructure in the Macau region.

"The new Chinese regime in place since 2012 supports Macau growth but they want to clean things up," said Dan Wasiolek, a gaming industry analyst at Morningstar. "They want a healthy Macau economy but not one that is driven by underground activity. They want to be more like Las Vegas, a destination site for gambling, but also a place for families to visit," he said.

Deflating The Macau Bubble

Wasiolek said no one can say for sure when Macau will return to positive revenue growth. While it is difficult to know when a recovery in gaming will kick in, Wasiolek said the intermediate and long-term Macau growth story remains intact.

He views Las Vegas Sands as best-positioned for long-term growth in the gaming industry because of Macau's attractive long-term growth prospects. Las Vegas Sands gets about 60% of earnings before interest, taxes, depreciation and amortization through its Macau operations.

"It is not unreasonable to expect Macau visitation and revenue to reaccelerate to above a mid-single-digit pace in a few years, as new casinos open," Wasiolek said.

Cameron McKnight, an analyst at Wells Fargo Securities, in a research note on Aug. 21, remained neutral on Macau gaming.

"We continue to believe there will be no V-shaped recovery as the liquidity induced 'Macau Bubble' of the past five years continues deflating," McKnight wrote. "We remain positive on the long-term outlook and see the case for 10% longer-term growth once revenues settle back to their longer-term trend.

Wynn, MGM and Las Vegas Sands have worked hard to cut costs during the downturn. Revenue at the Sands China unit fell 26% to $1.77 billion in the second quarter. Las Vegas Sands CEO Sheldon Adelson, in comments after earnings were reported on July 22, said "despite the continuing challenges in the Macao market, we delivered a solid set of financial results." He said that while the operating environment in Macao, particularly in the high-end gaming segments, remained challenging, Sands is weathering "this cyclical downturn better than the industry overall.

U.S. Casino Scene: More Game

While China goes through its transition, the U.S. market has gradually improved in the past few years as the economy strengthens.

Peter Trombetta, an analyst at Moody's Investor Service, in July upgraded the U.S. gaming industry outlook to stable, from negative, as the prospect for revenue growth improved.

Trombetta expects U.S. gaming revenue to increase 0% to 2% each month, year over year, over the next 12 to 18 months. That's a change from October, when he had forecast that revenue would fall 3% to 5%.

He expects earnings before interest, taxes, depreciation and amortization to grow in the 3% to 4% range.

"The monthly gaming revenue trends for most of the U.S. gaming market continues to be positive," said Trombetta.

He said gaming companies are reaping the benefits of lower cost structures and improved operating leverage following aggressive cost-cutting, although the cost cutting is likely to slow. Too much cost cutting can sacrifice quality and service, causing gamblers to place their bets elsewhere.

"While gaming company earnings will continue to benefit from cost-reduction efforts, casino operators may be running out of room to cut costs much further, absent a significant decline in gaming revenue," he said.

Trombetta would change his rating to positive from stable if gaming revenue increases more than 2% and operating profit more than 4% for two consecutive months, with the anticipation that those rates will continue to rise for the next six to 12 months.

Tracking The Next Generation

New facilities are contributing to the revenue-growth improvement. Three gaming casinos opened in Ohio this year, two by Penn National Gaming (PENN) and one by Pinnacle Entertainment (PNK). Another is Penn National's $250 million casino in Plainville, Mass.

MGM is currently building the $1.3 billion MGM National Harbor in Maryland, scheduled to open in the second half of 2016. It's also developing the $760 million MGM Springfield resort casino in Springfield, Mass., scheduled to open in 2017. Wynn is in the process of constructing a $1.6 billion casino in Everett, Mass., a suburb of Boston.

St. Louis-based Isle of Capri Casinos (ISLE) bolted 11% higher Wednesday after scoring a big fiscal first quarter earnings beat that came despite a 4% revenue gain that fell short of analyst expectations. Margins improved by 200 basis points during the quarter, due to cost cuts and expense controls.

Isle of Capri also said revenue rose at all four of its casinos in Missouri.

Trombetta warns, however, that gaming is a highly discretionary form of entertainment spending that can shift quickly.

"If consumer income is cut or if they're not confident, that form of entertainment is one of the first things they will cut," he said.

One long-term trend that Trombetta carefully tracks that could be problematic for gaming companies is gambling interest among younger generations. They've grown up with more extensive entertainment choices, fueled by broad advances in technology. They have a much wider range of options to spend their discretionary income on than did prior generations.

Aware of that trend, Nevada in May approved a bill to allow gaming equipment manufacturers to add a skill-based, arcade-style element to slot machines.

"Casinos are looking for additional sources of revenue, especially in regional markets where most revenue comes from slot machines," said Trombetta. "It will be interesting to see what comes out of this."