Over the last 12 months, Macau casino-gaming stocks have declined by 35% to 65% as gross gaming revenues (GGR) declined by 30%. We believe Macau’s GGR decline this year was a result of a “perfect storm” that includes tightening junket liquidity, hotel room constraints, the Chinese government’s anti-graft movement, and the rise in cancellations of Hong Kong/Macau packaged tours due to the “Occupy Central” protests in Hong Kong (Nearly 20% of the Mainland Chinese visitors to Macau last year also visited Hong Kong during the same visit.).

We believe these factors are transitory. Thus, the recent weakness in Macau casino gaming stocks provides a good buying opportunity. We find Melco Crown (MPEL) – whose stock price has declined by 40% over the last 12 months – to be particularly attractive. Here are three reasons why we like MPEL

1.     Very high barriers to entry which benefit established incumbents like MPEL

The casino gaming industry is highly regulated. MPEL is one of only six licensed casinos to operate in Macau, the largest casino market in the world. Macau is also the only city in Greater China (Hong Kong and Taiwan included) where gambling is legal. This is important because travelers visiting casinos do not want to travel very far (typically only three hours by flight).  Because of its unique status and location, Macau is the exclusive casino-gaming destination serving the 700-million-strong Chinese urban population, the largest addressable market in the world.

Ongoing infrastructure development will ensure Macau’s dominance as the gambling mecca of Greater China. For example, the first phase of the Macau Light Rapid Transit System, linking the Macau Peninsula, the Cotai Strip, and Taipai – including the Macau Ferry Terminal and the Macau International Airport – will be completed by early 2016. The Hong Kong-Macau-Zhuhai Bridge, also slated to be completed in 2016, will reduce travel time between Hong Kong and Macau from four hours to 40 minutes. Upgrades at the Macau International Airport will allow it to double its passenger handling capacity to 12 million per year. It will be completed by 2017.

These projects will speed travel time across Macau and ease capacity constraints at the Macau International Airport. By comparison, there are currently only 282 weekly direct flights to Macau from Greater China versus 2,300 weekly direct flights to Las Vegas from around the U.S.

2.     Favorable supply and demand dynamics going into 2015

We expect GGR of the Asian casino-gaming industry to grow from $62 billion in 2013 to over $100 billion by 2018. Macau will remain the central destination for Asian casino gaming, with its Asian market share steady at 70%, due to rising Chinese leisure & travel spending.

As mentioned, we see the “perfect storm” of tightening junket liquidity, hotel room constraints, and the Chinese government’s anti-graft movement as transitory (the “Occupy Central” movement just ended). Junkets (which cater to VIPs), for example, typically accept real estate as collateral. With Chinese housing prices declining by 8% this year, junkets are not extending as much credit to VIP gamblers.

We believe Chinese housing will recover in 2015 as the People’s Bank of China eases monetary policy. Moreover, casino operators are shifting their focus to the mass-market, which typically brings in greater profits (as they no longer need to pay junkets a commission).

On the other hand, mass-market gamblers tend to stay overnight and spend more on non-gambling activities. As of the end of 3Q, 2014, vacant rooms in Macau’s casinos dropped to only 1,000 rooms, a multi-year low. Hotel room constraints will ease next year. After growing by just 6% in the last two years, the number of hotel rooms is projected to grow by 13% (over 4,500 hotel rooms) in 2015, with MPEL’s new majority-owned casino-hotel, Macau Studio City, providing 1,600 of these rooms.

Finally, the Chinese anti-graft movement is nothing new. When China changed leadership in 2012, Macau’s VIP GGR also suffered a setback, but growth resumed by the second half of 2013. The Chinese leadership wants to diversify Macau’s revenues; not to kill its long-term prospects. Macau’s recent shift to a mass-market focus – providing more hotels rooms and retail shopping areas – aligns well with the Chinese leadership’s long-term intentions.

3.     MPEL’s growth prospects and valuations are both very attractive

MPEL’s new majority-owned casino, Macau Studio City, will open in mid-2015, increasing MPEL’s overall table count from 620 to 920. Macau Studio City’s 1,600 rooms will double MPEL’s hotel room count, accounting for nearly half of all hotel rooms coming online in Macau’s casinos next year.

Moreover, Macau Studio City is situated at a proposed stop of the Macau Light Rapid Transit System. The opening of Macau Studio City will thus position MPEL for substantial growth opportunities in Macau’s rapidly-growing mass-market. MPEL will also debut its City of Dreams Manila casino in the Philippines early next year. The Philippines is the world’s fastest-growing casino market, with analysts projecting 25% annual GGR growth over the next five years.

Finally, MPEL is trading at an expected 2014 EV/EBITDA multiple of 11.2, which is 20% cheaper than its 14.0 three-year average from 2011-2013. MPEL will also see substantial cash-flow growth once its current pipeline is completed. By 2016, MPEL’s free cash flow (FCF) yield should hit 4.5%, rising to 8% by 2017. Our analysis suggests a 50% return to MPEL’s stock price over the next 18 months as GGR growth resumes.

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Disclosure: Neither my firm, CB Capital Partners, not I hold any shares in MPEL.

For more information, please visit cbcapital.com. Click here.

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