Description

At less than 3x run-rate free cash flow, I believe Emperor Entertainment Hotel (EEH) presents an opportunity to buy a premium Macanese gaming property at less than one-fifth the valuation of any other casino stock in the world.  Since EEH also trades for less than the liquidation value of its net assets I also believe it is the safest way to gain exposure to Macau.  I believe that EEH is the ugly duckling left out of the Macau mania because of its obscurity, small size, and lack of obvious sex appeal.

A Brief Macau Primer

For those of you who couldn’t say what a Pataca is to save your life, Macau is a special administrative region of China, much the same as Hong Kong.  Macau hosts the only gaming permitted in China, and it is the best gambling in Asia.  Macau surpassed Las Vegas in 2006 as the largest gaming market in the world.  In Q1 2007 market gaming revenues grew by about 50% year-over-year on circa 20% visitor growth.  If it’s been a while since the last time you read a casino annual report you’ve probably missed the fact that many domestic casino operators (WYNN, LVS) actually garner a majority of their EBITDA from Macau.

Prior to 2002 the market was a regulated monopoly controlled for 40 years by Stanley Ho’s Sociedad de Jogos de Macau (SJM).  The market was stagnant prior to 2004 as only one casino existed (Casino Lisboa, which is still in operation and very profitable).  As one would imagine investment in the monopoly ran low and provided no fuel for market growth.  Lisboa became run-down and gamblers gathered around the tables five deep. 

Enter market liberalization.  Three original licenses were auctioned (to SJM, Galaxy and Wynn) and subsequently several more sublicenses were spun off.  Las Vegas Sands became the first major new entrant with the Sands Macau in May 2004.  The Sands was a nine month payback, and continues to be the most phenomenal casino I have seen from an ROI perspective. 

Fast forward to today.  Several large casino projects have sprouted up since the Sands, and with the flood of investment has come a flood of gamblers.  All of the development to date has been in downtown Macau.  Because space is limited downtown, new mega developments have broken ground on a strip of land below the Macau peninsula called the Cotai (COloane-TAIpa) strip.  The Venetian (Las Vegas Sands once again the first-mover) will be the first to open.  Being the first mover on Cotai is a bit like showing up at a nightclub at 8 pm.  Today it’s a completely barren strip of reclaimed land an unwalkable distance from downtown. 

Long-term Cotai will become a threat because casino real estate is obviously reflexive as we’ve seen in the migration from downtown Vegas to the Strip.  However I believe it will take many years before Cotai builds enough critical mass.  Besides, paying less than 3x free cash flow I believe we’ll make our money back and then some by then, plus we’ll have the residual value of the real estate, worst case.  But then it’s also possible that Cotai and downtown will survive in harmony as Cotai catches the spillover from downtown.  Many also believe that Cotai will attract a different demographic – e.g. the difference between Gold Coast and Excalibur in Las Vegas. 

Because we’re all conservative value guys the whole time you’re reading this write-up you may labor over the very real risk of win per table plummeting.  Through intensive research I’ve become a convert to the Adelson/Wynn school of casino economics (i.e. supply-driven market expansion).  I believe that new developments can still stimulate incremental demand in this early stage of market development in Macau.  I also believe that EEH is largely insulated from the threat of market capacity growth because of its unparalleled VIP franchise. 

The Grand Emperor Hotel

EEH owns and operates the Grand Emperor Hotel in the heart of downtown on the Macau peninsula.  The Emperor was opened in January 2006 (it has reported one full half).  The casino operates as a sublicensee of SJM.  Rather than putting up scarce capital for the gaming concession, management decided to operate on a revenue share arrangement with SJM.  SJM retains 20% of gross gaming revenues and shoulders 100% of the operating costs for the mass market business.  40% of gross gaming revenues go to taxes.  Emperor retains the remaining 40%.  Emperor retains 90% of their after-tax VIP gaming revenues.  The sublicense lasts for an initial term of 20 years.  SJM cannot reneg for any reason that I am aware – even so, a new sublicense would be easy to obtain. 

That SJM pays operating costs is an important stipulation.  Labor inflation in Macau is astronomical (probably 20% per year anecdotally).  I believe the arrangement will spare Emperor significant margin compression.  Meanwhile it strengthens Emperor’s position as other casinos struggle to staff their tables and chew into their profits.

The Emperor is situated in a very valuable location, a two minute walk from the historic Casino Lisboa and the newly-opened Grand Lisboa (next door to the old Lisboa), and a five minute walk from Wynn, and not much further from the Sands.  The Pharaoh is also close.  The Pharaoh is an underappreciated early-mover casino that still generates phenomenal traffic.  There’s also a mall going up right next door to the Emperor.  When I was there last it was still a skeleton so it’s probably several months from opening.  I believe it will be the only mall in Macau.  For a good map of Macau visit http://content.edgar-online.com/edgar_conv_img/2006/12/01/0001193125-06-245453_G45868G04Q48.JPG. 

Prior to 2006 EEH was a junket operator for Casino Lisboa.  A junket operator is a liaison between high rollers and casinos.  The junkets maintain the relationships and take a percentage of the gaming revenue.  Most casinos don’t maintain their own VIP rolls in Macau and so have historically relied on junkets to maintain relationships with high rollers. 

The Macanese VIP business differs from the Vegas high roller business in many ways.  Namely, the VIP business is much bigger than in Vegas.  There are simply many more high rollers in Macau than Vegas.  VIP revenues are still over 50% of market gaming revenues, compared to maybe 10% in Vegas. 

If you’re imagining newly-minted Chinese millionaires hopping over to Macau in their jets, you’d be largely wrong.  While spending an afternoon with the head of VIP marketing for the Emperor I asked how most of her clients make their money.  She responded matter of factly, “They are mostly gangsters from Shanghai and Beijing and a few professional gamblers.”  A visit to Emperor’s VIP halls confirms this – shifty-looking, young guys yelling, cursing (I assume), and wantonly throwing things is pervasive.  Nothing like Casino Royale for sure.

The point I’m getting at is this is not a crowd that you can read about in the papers and know that their credit is good, it takes years of relationships and getting to know this crowd.  The Macanese VIP business operates 100% on credit, and lots of it.  It isn’t unusual for a gambler to have $1 million in credit outstanding. 

The foreign casino operators – and more importantly the Nevada Gaming Commission – are uncomfortable granting credit to these guys without mandatory thorough research.  The Sands – magnificent casino that it is – is a VIP wasteland.  A visit to their VIP floor will turn up halls and halls of emptiness.  In the entryway is a desk with computers linked to a 24 hour office in Las Vegas staffed with lonely souls hoping to get someone approved for credit.  Imagine for a moment that you’re a 28 year old mobster in Macau for the weekend and you stroll up to the Sands VIP desk and you’re told that you have to undergo a background check, credit check and confirmation of your bank accounts.  Even if you do make it past the junkyard dogs there’s no one to play.  Very damaging to the ego, not to mention the valuable gambling time you’ve lost.  I’m not an egomaniacal gangster and I’m certain I wouldn’t sit for that kind of treatment when I can go across the street to the Emperor where credit is loose. 

The Emperor VIP hall is by far the fullest and liveliest and I believe most of the gamblers enjoy that; I think when some Macanese casino operators say otherwise they are playing to our western naivete.  Portfolio managers may enjoy sitting quietly in seclusion for hours on end, but not gangsters.

Because Emperor operates their own junkets their cost structure is lower since they don’t have to pay a third party junket, so Emperor can afford to pay their gamblers higher rolling commissions.  Rolling commissions are paid to high rollers for bringing new gamblers to the junket.  As you can see, this is a somewhat reflexive business.

Emperor’s VIP franchise is possible because they junketed for the only casino in Macau for years, then stole their clientele when the market was opened.  The VIPs interfaced with Emperor, not SJM.  When the Grand Lisboa opened the VIP table count there was exactly zero and they are still unsure when and how many VIP tables they’ll open.  Today the VIP halls in the old Lisboa are among the most desolate.  Starting new relationships with VIPs is difficult and risky, so it’s a sticky business. 

To shift gears, Emperor’s mass market business is frankly unimpressive but profitable.  The concourse is small and unexciting compared to the massive halls at Grand Lisboa and Sands, but the tables are full.  If not for the gargantuan LEDs on the exterior, beefeater guards armed with automatic weapons at the door, and $2 million of gold bars set into the lobby floor, the casino itself is undistinguishable from an office building.  Given that the VIP business contributes more than 3x the EBITDA that the mass market business does, I can live with average. 

The ugliness is a virtue though.  It’s obvious that management built the Emperor for ROI.  Were the Emperor to be at the far end of Coloane I would be very concerned for its weak mass market offering. 

I don’t think I can overemphasize the value of Emperor’s location.  I believe it sits on some of the most valuable property in Macau, and Macanese real estate is the most valuable real estate in the world.  EEH owns the property virtually free of debt.

You Worry Too Much

The risk, defined as what we don’t know, to incremental buyers of EEH is markedly lower today than before the opening of Grand Lisboa in February.  You must understand how big a threat Grand Lisboa posed – I’m embarrassed to say I didn’t until it was already built. 

Grand Lisboa is simply an impressive casino built by the smartest operator in Macau, and it was a stone’s throw away from the Emperor.  It is by a wide margin the casino I admire most in Macau or Vegas, and I’ve seen them all in and out.  The exterior wins the most wow points of any I’ve seen.  The structure is built in the shape of a torch and covered with gold-plated glass.  I suggest you Google it to get an idea.  The concourse is awe-inspiring.  Measuring probably 100 yards long and 50 yards across, it still has no problem filling its tables to the gills – not one empty table, and I would say they average two deep.  It’s a testament to the vibrancy of the Macanese market that it didn’t decimate the Emperor.  Perhaps more telling is that the old Lisboa, directly next door to the Grand Lisboa, is still very full and certainly more profitable than most Vegas casinos. 

It’s my opinion that if Grand Lisboa couldn’t destroy the Emperor, that the single casino risk is unlikely to be a material risk going forward.  The Grand Lisboa is the best evidence I have that win/table won’t easily be whittled away.  Other evidence abounds. 

Monthly market statistics (apologies for the spottiness):

                        Seats                Rev¹    Rev/Seat          Notes

June 2006        16,248             489      30,090

July 2006         16,322             557      34,107

August 2006    18,335             572      31,197             Sands expansion

Sept 2006        19,959             558      27,972             Wynn opens

Oct 2006         21,890             715      32,650

Dec 2006         23,118             734      31,763

Feb 2007         25,750             696      27,020             Grand Lisboa opens

Mar 2007        25,169             778      30,911

¹Millions of USD

It seems that the market is absorbing the capacity comfortably.  Or another way to look at it is that the new developments are generating their own demand, and carrying their own weight.  The middle ground, which is supported by the data, is that the growth of the market is meeting pent-up demand.  Visitor growth isn’t keeping up with capacity growth and probably won’t in our time horizon.  Instead, spending per visitor is growing rapidly.  When I think about my own gambling habits, my gambling budget is going to be much higher if there are 20 casinos nearby than if there is only one because I get bored and want to try another casino, or I pop into a casino on the way to dinner, etc.  I think it’s clear that some market expansion is good for everyone.  Grand Lisboa may take some spend away from the Emperor in the short-run but it’s just as likely to draw gamblers into the area.  Most importantly, long-term the Grand Lisboa helps strengthen the neighborhood. 

Lastly, as always, one has to seriously consider what a number really tells you.  It’s easy to fall into the trap of assuming that because an average declines that all boats fall with the same tide.  It’s possible, and likely in some cases, that the incremental table has a much lower win than the previous average and so pulls down the average with little to no deterioration in existing tables. 

Prediction: When the April and May market numbers come out we will see a healthy decline in revenue per position coinciding with the opening of Crown Macau’s (Melco) 2,200 gaming positions.  I am certain this won’t be because of any material shifts in market share.  It will be because Crown will put up pathetic numbers.  Crown is situated squarely in the armpit of Macau, built I suspect more to bilk Americans out of their investment dollars than to bilk Chinese out of their gambling dollars.

I believe market revenue per seat will grow nicely over the next several months.  There will be a lull in promising launches until Q4. 

2007 Launch Schedule:

Project             Date     Positions         Notes

Crown             April    2,200               See above

Wynn Exp.       July      1,484               Terrible VIP offering

Venetian          Q4        9,200               Cotai

MGM Grand    Q4       3,105               Nice addition to Emperor’s neighborhood

Greek Mythology Exp  4,650              In the Crown armpit, run-down & declining traffic

Pier 16                         725

Total                            21,364

The only remaining project in 2007 that remotely concerns me is MGM, but again I don’t consider it nearly as concerning as Grand Lisboa.  I think it’s good for nearby property values.

2008 Launch Schedule:

Project             Date     Positions         Notes

Four Seasons   Q1       1,180               Cotai

City of Dreams 1H      5,700               Cotai

Galaxy Mega               4,600               Cotai

MGM Expansion         1,565

Sheraton/St. R.Q3       3,700               Cotai

Shangri-La       Q3       3,700               Cotai

Total                            20,445

Basically by the end of 2008 there will be nearly as many seats in Cotai as in the whole market today. 

2009 Launch Schedule:

Project             Date     Positions         Notes

Studio City                  3,400               Cotai

Far East Cons. Q3       3,700               Cotai

Hilton/Conrad Q3       3,700               Cotai

Fairmont/Raff. Q3       3,700               Cotai

Total                            14,500

Miscellany

Prior to last week EEH also operated a gambling boat.  EEH sold the boat for HK$175 million.  The price isn’t juicy relative to $30 million of free cash flow.  It should be emphasized however that the business was deeply flawed in my view.  For starters it was a cruise out of Hong Kong harbor.  If passengers finished gambling early they couldn’t leave.  If you weren’t finished gambling upon returning you couldn’t stay.  When Macau is a one hour boat ride out of the same harbor I see no reason for this business to exist, and wouldn’t be surprised to see it go into decline – there was certainly no growth potential at the very least.  Furthermore, the boat wasn’t complimentary to the casino at all.  I am thrilled to see EEH streamlining.

EEH is also a 50% partner in a mall project in Shanghai.  EEH’s equity contribution will consist of the land, which I believe is worth HK$700 million at market.  EEH owns the land 100% and free of debt.  In the event EEH wants to back out of the project EEH may put their share to the other partner for HK$530 million. 

It makes no sense for a casino operator to develop malls in Shanghai.  Because the parent company Emperor International (163.HK) is a property developer there’s obviously been some cross-pollination.  This project is begging to be transferred to 163.  I would love to see 163 pay for it with the 296 stock that it owns, but I strongly doubt that would happen.  Given that in the last month this management team has sold the gambling boat and spun off a non-core business from 163, I think it’s apparent that they are intelligent and active about value-realizing transactions. 

The Numbers

I’m going to break this discussion into impossibly granular detail that can only be reconciled by speaking to management.  Company reports will not provide this level of detail unfortunately.  The company does have a thorough presentation confirming most of the details.  I’ve posted the IR contact info at the end of the writeup.  Note that EEH reports on a March fiscal year.  Also note that EEH effectively owns 45% of Grand Emperor Hotel with minority investors owning the other 55%.  As such EEH is entitled to 45% of the concourse, slots and hotel EBITDA.  VIP doesn’t count as part of the hotel, so  EEH keeps 90% of VIP EBITDA.  EEH doesn’t pay income taxes since they elect to pay gambling taxes instead.

VIP

In an obviously underappreciated announcement made at the time of the gambling boat sale, EEH announced the opening of four additional VIP tables.  It’s possible that the market believes the new tables will simply cannibalize the older tables.  What management didn’t publicize is that these new tables don’t address the same market as the older ones.  The new tables will be mega high roller tables.  It has been intimated to me that the existing roll of VIPs won’t even know about these new tables.  The new hall will have its own secret entrance in an obscure part of the hotel garage and will not be accessible from the rest of the casino.  I believe this is a substantial step toward strengthening the Emperor’s already solid VIP franchise, as I believe no other casino in Macau has a comparably exclusive VIP offering.  It is spurious to try to predict what win per day will be for these tables, so I will just assume the net win per day will be similar to the old tables – higher volume per player, lower traffic. 

1H 2007 win/table day was HK$676,000 (not a typo – that’s about US$85,000/day).  Management feels that 2H win/table will increase sequentially.  As Grand Lisboa didn’t open with any VIP tables there would’ve been no drag on win/table. 

If you want to get more granular, gross roll per month is about HK$5 billion – apply a 2.7% net win percentage and divide by 30 days then divide by number of tables and you’ll get your net win per table day, give or take. 

To arrive at net revenue for a period apply the following formula:

Win/table day x Days x Tables x 40%

Rolling commission is officially .85% of gross roll, but I’ve short-handed it by making it 78% of net revenue.

                                    1H 2007          Run-Rate

Tables                         6                      10

Win/Table                   655                  700

Net Rev.                      288                  1,000

Oper. Costs                 9                      30

Rolling Comm.            225                  780

EBITDA                      54                    190

EEH’S 90% Share      49                    170

Capex                          2                      5

FCF                             52                    185

EEH’S 90% Share      47                    165

The Emperor also leases out several VIP tables to junket operators, which generates about HK$35 million in rental income per year with no associated expenses.  This income is reported in the hotel segment.

Mass Market Concourse

In 1H 2007 win/table day in the mass market concourse was HK$28,000.  After the Grand Lisboa opening I’m told that win/day bottomed out at about $26,500.  Since then win/day has set a new record in March – win/day recovered to previous levels after about 45 days.  Net revenue is 40% of gross win.

                                    1H ’07   Run-Rate

Tables                         48          52

Win/Table Day            28          29     

Net Rev/Table             11          11.6

Net Revenue                94          220

Oper. Costs                 58          120

EBITDA                      36          100

EEH’s 45% Share       16          45

Capex                          6            12

FCF                             30          88

EEH’s 45% Share       14          40

Slots                1H ’07   Run-Rate

Seats                340        348

Win/Seat Day  940        1,000

Rev/Seat Day¹ 290        400

Net Revenue    18          51

Maint. Cost      16         32

EBITDA          2            19

EEH’s Share   1            9

Capex              5            10

FCF                 -3           9

EEH’s Share   -1           4

¹Note that the revenue share arrangement with SJM was increased subsequent to the first half from 31% to 40%. 

Hotel               1H ’07   Run-Rate

Rooms             291        291

Occupancy       81%       85%

Avg. Rate        805        800

Room Rev.      35          72

F&B Rev.        30          60

VIP Rental       17          34

Mkt. & Prom.  43          86

Other Rental    8            16

Total Revenue 133        268

Operating Exp¹100        180

EBITDA          33          88

EEH’s Share   15          40

¹Management believes that marketing costs were about HK$10 million per half higher in 1H than current run-rate because of launch costs.

Note that hotel operating expenses include a negligible amount of capex, so EBITDA is the same as free cash flow.

Reality Check

1H Gaming/Hotel Est.

Total Rev.       533

EBITDA          125

1H Ship & Corp.

Total Rev.       61

EBITDA          11

Total Est.         1H Actual

Revenue          594                  593

EBITDA          136                  133

Today’s Valuation

Stock Price      1.56

Shares             929

Market Cap     1,450

Land                600      HK$350 mill cost basis, 25% tax rate

Cash                300

Debt                122

EV                   670

So shorthand we can see EEH is trading for 2.5x 1H RR EBITDA.  We know that current earnings power is considerably higher given that they’ve expanded their VIP capacity by 67% with little addition to overhead.

Valuation

Base Case       FCF     Mult.    EV

VIP                  165      10        1,650

Mass Mkt.       40        8          320

Hotel               40        9          360

Corporate        -10       10        -100

Total                235                  2,230

Shanghai Land                         600

Cash                                        300

Debt                                        122

Equity Value                            3,000

Shares Outstanding                  929

Stock Price                              3.25

Best Case        FCF     Mult.    EV

VIP                  180      13        2,340

Mass Mkt.       44        11        485

Hotel               44        12        530

Corporate        -10       13        -130

Total                258                  3,225

Shanghai Land                         1,000  

Cash                                        300

Debt                                        122

Equity Value                            4,400

Shares Outstanding                  929

Stock Price                              4.75

Keep in mind that these numbers are run-rate, not 2008 or 2009 as other Macau stocks are valued.  If EEH retains the mall project, it is expected to generate HK$100 million of free cash flow, at which point it would be worth more than HK$600 million.  Note that the ‘Due to Minority Shareholder’ liability in the balance sheet isn’t real, it’s a bizarre accounting technicality. 

Downside (or lack thereof)

EEH and the minority shareholders put about HK$1.4 billion into the hotel property.  The most recent appraisal valued the property at about HK$2 billion.  EEH’s 45% share would be worth HK$630 million at cost, and HK$900 million at market.  An adjacent lot owned by SJM is empty and could be used to develop a larger casino. 

Macau Property           900

Shanghai JV Put           485      HK$530 put, $350 basis, 25% taxes

Net Cash                      180

Net Asset Value          1,565

Current Market Cap     1,500

It would seem harder to get downside as a going concern – how much would win/table have to go down before we’re at a respectable multiple?

IR Contact:

Sidney Luk

[email protected]

852-2835-6715

Sidney is very knowledgeable, especially for a small company IR rep.

Vanessa Fan

[email protected]

852-2835-6678

Vanessa is sort of the COO of the casino business, but she also works with 163 as well.

Company Web site: www.emp296.com

Hong Kong “EDGAR”: http://www.hkex.com.hk/listedco/listconews/search/search_active_main.asp

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