Gambling With a 9% Dividend Yield

Johan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Chinese gamblers like Macau, just as Americans love Las Vegas. The big difference is that Macau generates five times more in gross gaming revenues than the casinos on the Las Vegas Strip.

The reason that Macau is booming is because it is the only place on Chinese soil where table gaming is permitted. Gambling has been legal for more than 150 years in Macau. In 2011 Macau boasted 28 million visitors, a number expected to rise to 50 million in the next few years. But the slowing economy in nearby China means things are tighter than they have been in a long time.

But it's at times like this that Macau gets busy reinventing itself, and there's no shortage of interested parties. Local and international casino operators are spending billions on resorts that combine casinos with shopping centers and entertainment venues to try to woo China's growing middle class. The Chinese government is repositioning Macau as an international leisure destination.

The key to Macau's recent boom has been the junket operators who find and offer credit to VIP high-rollers from the mainland. High-spending Chinese gamblers make up 70 percent of revenues; these high-rollers can drop hundreds of thousands of dollars at a table without the ash on their cigarettes trembling. But the VIP side of the business has been hurting; that slowdown in China is starting to hit profits. The junket operators traditionally give the high-rollers credit based on the value of their property portfolios, but the end of the real-estate boom has seen this kind of credit fall off.

However, where the high-rollers are falling off, the number of middle-class Chinese is on the rise. The baccarat tables are packed with moneyed mainlanders.

From the 190 junket operators in Macau, investors can profit from one that is listed on the US capital markets. The company is called Asia Entertainment & Resources (NASDAQ: AERL). In July, 2010, AERL was listed on the NASDAQ Global Market.

Asia Entertainment is an investment holding company which operates through its subsidiaries and related promoter companies as a VIP room gaming promoter, and is entitled to receive all of the profits of the VIP gaming promoters from VIP gaming rooms. The company's VIP room gaming promoters currently participate in the promotion of four major luxury VIP gaming facilities in Macau. One VIP gaming room is located at the top-tier 5-star hotel, the Star World Hotel & Casino in downtown Macau, and another is located in the luxury 5-star hotel, the Galaxy Macau™ Resort in Cotai, each of which is operated by Galaxy Casino, S.A. The third VIP gaming room is located at the Venetian Macao-Resort-Hotel in Cotai which is operated by Las Vegas Sands Corp.  The fourth VIP gaming room is located at the City of Dreams Hotel & Casino in Cotai which is operated by Melco Crown Entertainment Limited.

Junket System

VIP-gaming in Macau is operated mostly through the junket system, where the junket operators and their agents own their relationships with VIP customers. These junket operators and agents, such as Asia Entertainment, provide a number of functions that the casinos outsource:

  1. marketing and the solicitation of business
  2. currency exchange
  3. providing work capital, and/or
  4. credit collection

Functions 2-4 have arisen due to: a non-free market Renminbi exchange system, the illegal status of gambling in China, which means casinos cannot enforce the collection of gambling debt via the courts, and the lack of credit information on individuals in China, in turn marking credit assessments on VIP customers a difficult and imprecise task for the casinos.

Junket operators are rebated either on the rolling-chip volume generated by their customers at the gaming tables, or by sharing the winnings the casinos make from this gaming volume. Assuming a 2.85% win rate for VIP Baccarat, the main game played in Macau's VIP rooms, a 1.25% commission on rolling-chip turnover would be equivalent to a 44% share of the table wins. The regulatory commission cap of 1.25% of rolling-chip turnover applies to rolling-chip commission. However there is no regulation governing the revenue-sharing split between junket operators and the casinos. The junket operators usually share 40-50% of table wins.

Asset-light model  

The company operates an asset-light model, and puts its capital into working capital, including credit provisions to facilitate gaming turnover. Asia Entertainment receives commission from casinos and pays its agents, usually keeping 0.45% out of the 1.25% as operating profit before general and administrative expenses. While its business model means it puts the money into working capital, there is no fixed-asset requirement. The company finances its working capital via shareholders' equity and loans.

The company has been profitable since their NASDAQ debut and has a dividend yield of around 8%. AERL trades below book value ($4.96) at $3.86 and has a P/E below three. The company also has a healthy profit margin of 30% and levered free cash flow above $20 million. With this cash flow the company can maintain a sustainable dividend and execute share buy backs.

Valuation

AERL is trading currently at a 2012E EV/EBITDA multiple of 3.73. There is no direct comparison available for other gaming promoters. While I notice that the casinos and VIP-gaming promoters have different business models and structures, for reference I have provided the valuations for the Macau casino operators. The average EV/EBITDA for Macau casinos is much higher than the one of AERL. 

<table> <tbody> <tr> <td> Company</td> <td>SJM Holdings</td> <td>Sands China</td> <td>Wynn Macau</td> <td><strong>Melco Crown</strong></td> <td> </td> <td>Asia Ent & Res</td> </tr> <tr> <td> Ticker</td> <td>880.HK</td> <td>1928.HK</td> <td>1128.HK</td> <td><span class="ticker" data-id="209726">(NASDAQ: <a href="http://caps.fool.com/Ticker/MPEL.aspx">MPEL</a>)</span></td> <td> </td> <td>AERL</td> </tr> <tr> <td><strong>Valuation Measures</strong></td> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> </tr> <tr> <td>Market Cap </td> <td>112.35B</td> <td>296.42B</td> <td>119.06B</td> <td>10.26B</td> <td> </td> <td>162.85M</td> </tr> <tr> <td>Enterprise Value (Jan 12,   2013)</td> <td>95.74B</td> <td>298.19B</td> <td>119.05B</td> <td>10.89B</td> <td> </td> <td>256.55M</td> </tr> <tr> <td>Trailing P/E (ttm)</td> <td>21.01</td> <td>33.65</td> <td>20.13</td> <td>24.66</td> <td> </td> <td>2.13</td> </tr> <tr> <td>Price/Sales (ttm):</td> <td>2.36</td> <td>51.22</td> <td>32.03</td> <td>2.62</td> <td> </td> <td>0.64</td> </tr> <tr> <td>Price/Book (mrq):</td> <td>6.62</td> <td>62.98</td> <td>30.05</td> <td>3.19</td> <td> </td> <td>0.76</td> </tr> <tr> <td>Enterprise Value/Revenue (ttm)</td> <td>2.00</td> <td>50.76</td> <td>31.48</td> <td>2.73</td> <td> </td> <td>1.03</td> </tr> <tr> <td>Enterprise Value/EBITDA (ttm)</td> <td>13.51</td> <td>215.80</td> <td>114.98</td> <td>12.49</td> <td> </td> <td>3.73</td> </tr> <tr> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> </tr> <tr> <td><strong>Profitability</strong></td> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> </tr> <tr> <td>Profit Margin (ttm):</td> <td>12.63%</td> <td>18.39%</td> <td>23.20%</td> <td>10.46%</td> <td> </td> <td>30.60%</td> </tr> <tr> <td>Operating Margin (ttm):</td> <td>12.47%</td> <td>19.37%</td> <td>23.92%</td> <td>12.66%</td> <td> </td> <td>25.34%</td> </tr> <tr> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> </tr> <tr> <td><strong>Management Effectiveness</strong></td> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> </tr> <tr> <td>Return on Assets (ttm):</td> <td>11.50%</td> <td>N/A</td> <td>N/A</td> <td>4.83%</td> <td> </td> <td>11.06%</td> </tr> <tr> <td>Return on Equity (ttm):</td> <td>38.18%</td> <td>N/A</td> <td>N/A</td> <td>12.31%</td> <td> </td> <td>43.48%</td> </tr> </tbody> </table>

Data provided by Capital IQ, except where noted.

Final Note

Of course we could think Asia Entertainment & Resources is another Chinese fraud listed in the U.S., but Wake Up Investors. Why would the company pay dividends and seek for a dual listing in Hong Kong?

Some junket operators have in the past been linked to China's notorious triad criminal gangs and some have murky dealings when it comes to collecting debt from customers. Asia Entertainment, with a market cap of $162 million, says it is one of the first junket operators trying to explain how the junket business works, aiming to shake off the industry's dodgy reputation.

The company's balance sheet is real and figures can be verified from casino owners. Their numbers are also submitted to Macau's Gaming Inspection Bureau. Junket operators have been around for decades and they are an essential part of the Macau gaming landscape.

AERL's stock price is ready to take off to a more realistic valuation. A P/E of 10 would mean the stock price could rise to levels of $15 or more, potentially making this a five bagger stock in the making!

 


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The author is long AERL. 

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