From a top down perspective, Macau gaming stocks tend to have a high correlation to the overall macro environment in China.  Specifically, softness in the economy and property prices have a direct impact on the VIP segment.  Majority of the high rollers in Macau come from old economy industries including real estate, materials and infrastructure.  If we look at gross gaming revenue trends (GGR) for the VIP segment, growth decelerated from +35% YoY in 3Q17 to -15% in the last few quarters, following the overall deceleration in the broad economy over the past few quarters. 

 

In addition to the slowdown of the overall economy, few other factors also provided headwinds to the sector.  With the RMB under pressure from trade war, capital controls remain tight in China resulting in very tight liquidity conditions, which ultimately has a ripple effect in Macau.  Furthermore, latest unrest in Hong Kong has disrupted visitor connectivity from HK to Macau given disruption at airports and ferry terminals.

 

Despite the top-down negative headlines, the fundamental structure story is still compelling, in particular driven by (i) incremental supply coming online which will drive growth in penetration, (ii) resilience in mass market which is key EBITDA growth driver (vs. VIP segment) and (iii) attractive valuations and strong FCF generation.

 

Macau generated $38bn in gaming revenue in 2018, 6x more than Vegas.  Similar to what we experienced in the US with growth in Las Vegas, penetration growth in Macau is partially driven by availability of supply.  Core component of GGR growth consists of volume/visitation which is driven by unmet demand, infrastructure development and hotel supply.  Vegas penetration, calculated as visitors/US population grew from less than 4% in 1970 to more than 13% today, primarily driven by increased supply of hotel rooms and other types of entertainment.  Looking at Macau, where over 70% of visitors are from China, penetration ratio (as % of Chinese population) is less than 2% and less than 3% if we only take into account China’s urban population (more representative given higher GDP/capita and higher propensity to visit and spend in Macau).  Looking at the tailwinds on why penetration will increase longer term is the rise in GDP per capita and increase middle class consumption which is estimated to reach $10 trillion by 2030.  

 

A more immediate and positive catalyst is improvements in infrastructure which will drive visitation growth.  Over 40% of the Chinese visitors to Macau come from Guangdong.  Key infrastructure projects that will expand the land transportation network will diversify and expand penetration of Macau beyond Guangdong province.  For example, China high-speed railway, which opened in Sep 2018 and connects China inland cities  to HK, shortened travel time from Shenzhen to HK to 10 mins and from Guangzhou to HK to 1.5 hrs.  The opening of HK-Zhuhai-Macau bridge in Nov 2018 improved access to Macau via HK airport (70mn passengers per year).  Prior to the opening, visitors to Macau needed to first go to Kowloon/HK ferry terminals (30-40mins from airport) and then take a ferry to Macau (50-60 mins).  The bridge reduces overall travel time from ~2 hrs to ~30 minutes and cost has gone down from ~HK200 to ~HK50.  Visitors from tier 1 cities are expected to growth MSD over the next 3-5 years while tier 2 cities will growth at LDDs. 

 

More importantly, disciplined and visible hotel supply will drive growth in Macau over the next 3-5 years.  Larger number of hotel rooms will allow guest to stay longer and are key to driving growth in overnight visitors, which are more lucrative than day-trip visitors. Occupancy rates remain high averaging in the range of 90-95% in 2019 despite numerous large number of openings over the past few years (Wynn Palace and Parisian 2016, MGM and City of Dreams 2018).  Looking at the capacity expansions, casino hotel rooms are expected to grow from 26,000 in 2019 to 30,000 in 2022, with most the growth coming from SJM, Galaxy and Sands. Looking at past performance of Macau stocks, we’ve seen a direct correlation between EBITDA growth and capacity expansion with stocks outperforming 6-12 months in advance of major capacity additions.  

 

From a fundamental structural point of view, the main positive transformation has been the change in mix contribution to EBITDA from VIP to mass market gaming.  As highlighted before, while a weak VIP market is weighing heaving on overall GGR, mass business continues to grow at a healthy rate driving margin, EBITDA and FCF growth.  EBITDA margins for VIP segment is ~10% while it’s 30-40% for mass.  Main differential in the cost structure between VIP and mass is that VIP carries the highest ratio of variable costs which is driven by high rebates to VIP customers and junket (promoter) commissions.  ~80% of total junket commission which represents ~1%+ of rolling chip or 45% of VIP revenue is returned to players as rebates.  The remaining 20% of the commission is part of opex.  

 

With the exception of 2014 when mass showed its first decline in history due mainly to anti-corruption efforts, mass gaming has grown steadily and now represents ~55% of GGR (vs. 25% in 2011).  While VIP GGR continues to post negative growth (although we think we have reached a bottom), mass continues to grow a HSD/LDD despite lack of new capacity.  If we look at aggregate EIBTDA for the overall market, it has grown from ~HKD40bn in 2011 to HKD70bn today with EBITDA margins growing from ~18% to 23% today.  Mass business is now the largest contributor to EBITDA growth primarily due to high volumes and higher percentage of fixed costs resulting in higher operating leverage.  

 

As we highlighted before, the core of our bullish thesis for names in Macau is the combination of supply driven growth via capacity expansion and the structural shift to mass gaming over the past few years which will drive EBITDA and FCF growth given the operating leverage embedded in the business.  Despite high visibility in the growth and improving margin profile, valuations for the names in the sector are currently trading under 12x EBITDA which is ~1SD below historical average of 15x.  With most of the capex already factored into the balance sheet, sectors are currently trading at close to 7% FCF.  Looking at the specific names in the sector, we think Galaxy, SJM, MGM and Sands will have the highest upside as they have the highest exposures to mass and slot gaming revenues (b/w 45% and 57%) and are drivers of capacity growth over the next 3 years.