There are a lot of reasons to stay far, far away from an investment in Melco Crown Entertainment (NASDAQ:MPEL), a pure-play Macau casino owner of City of Dreams and Altira Macau. A number of public Chinese companies have been exposed as publishing misleading or outright fabricated financial statements, costing investors (including billionaire John Paulson) a good deal of money. Even taking Melco Crown’s numbers at face value, a number of big guns in the casino business are moving into its turf in Macau over the next several years, increasing competition. And the casino business in Macau is highly leveraged to Chinese economic activity, which in turn depends on both U.S. consumer spending (explaining the stock’s beta of 2.3) and Chinese political stability.
The market, however, is well aware of these risks and has priced them into the stock- perhaps a bit too much. Melco Crown Entertainment (NASDAQ:MPEL) trades at 15 times trailing earnings; while sell-side analysts expect a rocky period over the next few quarters, bringing the forward P/E to 16, they expect that over time investors will win as the five-year PEG ratio is only 0.6. According to analyst research, Macau gaming revenue will be up about 7% in August 2012 compared to a year ago, suggesting that weak consumer spending in the U.S. and the effects it is having on China are putting very little of a damper on the casino business in the latter country. This comes after Melco Crown reported earnings growth- though a decrease in revenue- in the second quarter of 2012 compared to the same period in 2011. This was due to declines at Altira Macau but substantial gains, including 13% higher revenue, at City of Dreams.
A few hedge funds have taken note of Melco Crown’s pluses and stepped up to put their money on the company. Billionaire Paul Singer’s Elliott Management, which didn’t stay in business for 35 years by throwing money away, increased its holdings by 64% in the second quarter of 2012 to 7.2 million shares. Elliott had initiated its position in the last quarter of 2011 (see more stock picks from Elliott Management). Luxor Capital Group, managed by Christian Leone, massively increased its existing stake in Melco Crown to 13.8 million shares. According to the fund’s 13F, Melco Crown was its fourth largest stock position at the end of June (find more of Luxor Capital’s favorite stocks).
Most of Melco Crown’s peers are U.S.-based casinos which have substantial worldwide operations and are looking to expand into the Macau market (or have already entered it). Several U.S. states are looking to increase citizens’ access to gambling, including new casino locations, in order to raise revenues; this is likely to be a boon for U.S. focused casinos as long as the expansion of gambling does not get too big and increase competition more than demand (for example, through legalizing online gambling). Las Vegas Sands (NYSE:LVS) trades at 25 times trailing earnings, and here the sell-side is quite optimistic about the company’s prospects for next year: on a forward basis the P/E is only 16, even with Melco Crown’s. Las Vegas Sands is looking to aggressively expand in Europe over the next several years in addition to its positioning in Las Vegas and Macau. Wynn (NASDAQ:WYNN) also has an Americas-based price premium (though it too has Macau locations), trading at 21 times trailing earnings and 17 times forward earnings estimates. Wynn, like Melco Crown, saw decreased revenue and increased earnings in its last quarter compared to a year ago. MGM Resorts (NYSE:MGM) is expected to be unprofitable both this year and next year, though in both quarters so far in 2012 its losses have been less than expected.
We think that the market may be overpricing various risks to Melco Crown Entertainment (NASDAQ:MPEL). Las Vegas Sands and Wynn have their own Macau operations, and their betas of 1.8 indicate that they are about as exposed to U.S. weakness. There is a risk to going with a pure play here, but the earnings multiples are quite attractive and at least so far Macau appears to be doing well. We might not recommend it on an absolute basis, but we would say it is underpriced relative to its peers.
