The New "Big Short" on China Is On

After years of government stimulus, China has finally begun to experience economic slowdown. While this is no secret to investors, Stanley Wang of Pareto Capital Management in Atlanta has identified “the Big Short” on the Chinese economy: Macau.

Government stimulus yuan are flowing to wealthy developers with a strong gambling culture and in turn flowing to over-built and over-leveraged Macanese casino operators such as Melco Crown Entertainment (NASDAQ ADR: MPEL). Wang’s gamble is that once stimulus slows, the world’s largest “Sin City” will see a crushing drop in revenues. Though his short pitch on MPEL has already returned about 25% since July, Wang says this is only the beginning; shares currently trading at $16 could be worth as little as one dollar by the time the dust settles.

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SumZero: What about Melco Crown and Macanese gambling initially caught your attention as a value investor?

Stanley Wang, Pareto Capital: Michael Lewis's The Big Short described one particularly effective way to short mortgages - shorting the "safer" derivatives on mortgages. There were many mortgage derivatives (e.g. senior tranches of CDOs) that were rated AA (that is, slightly riskier than AAA-rated US government debt). Yet, the underlying assets were of junk quality. As a result, the resulting payout was $50 to $1 invested versus the $10 to $1 of shorting the riskiest mortgages. Shorting Macau-based casinos such as Melco Crown Entertainment Ltd. (Nasdaq: MPEL) may be the AA trade for shorting China risk.

MPEL is a Macau-based developer and operator of casinos and entertainment resorts and makes money mostly from Chinese tourism. As Macau is the one area in China where gambling is legal, MPEL is essentially an investment in Chinese gambling. However, increasing and sticky supply of casinos, decreasing demand from China, and a heavily leveraged capital and operating structure make a short favorable.

SumZero: What is the market missing?

Stanley Wang, Pareto Capital: Melco Crown serves as another way to implement the short thesis for the China fixed-asset bubble, which is that the stimulus/spending plan that the Chinese government had instituted around 2008 has reached the limits of effectiveness. This thesis is relatively well-known now and focuses on the use of stimulus to build over-priced and under-utilized buildings and infrastructure.

One of the most profitable ways to short this bubble as it deflates has been commodity companies (e.g. iron ore miners and met coal companies). By the end of 2014 many of these companies were near bankruptcy, so the risk-reward wasn't nearly as compelling. I therefore started looking for companies/industries with high capital expenditures, high debt loads, revenue that directly benefited from the stimulus, and ambitious expansion plans.

Melco Crown and the Macau-focused casinos fit all of these bills as the market gives them double-digit earnings multiples, even though their profitability per customer is many times higher than pre-2008. In other words, the stimulus is the sole reason for their current earnings power. If the stimulus ends and earnings per customer revert to historical pre-2008 China-norms, these casinos are currently very over-priced.

SumZero: Do you attribute this increased profitability solely to the 2008-present Chinese economic stimulus program?

Stanley Wang, Pareto Capital: The evidence is not 100% conclusive; however, looking at the spike in the growth rate of gross gaming revenues right around the financial crisis, one wonders what else could be the reason? The cause of the spike is not the overall growth of the Chinese economy because GDP growth has been actually been slowing since 2009. It is also not the growth in the consumer. Fixed asset investment (or gross capital formation) remained relatively steady or has grown as a percentage of GDP. So, consumers are investing just as much or more in physical capital and are not getting a bigger piece of the economic pie.

I believe it's a relatively small amount of people who made a lot of money lending/building using government money and wanted to celebrate their good fortune gambling in Macau.

SumZero: How much of the positive returns to date on your short MPEL trade would you attribute to broader weaknesses in Chinese markets as opposed to the industry and company specific factors? [Wang’s short on MPEL has had a 27% return to date]

Stanley Wang, Pareto Capital: Returns in general, in my opinion, are 40% broad Chinese markets, 40% industry, and 20% MPEL. Broad measures of the Chinese economy (e.g. from the government itself) are flat to slightly negative, despite new stimulus measures which could be a signal that industry metrics could revert to pre-08 levels. The leveraged capital structure of the gambling industry and MPEL means that a tough operating environment makes future earnings projections tough to hit. However, month to quarter-long price changes are more momentum/trend-based and based on the perception of the factors above.

SumZero: Is Melco Crown still attractive to short at today’s prices?

Stanley Wang, Pareto Capital: Yes, I view shorting around the current price of $16 is still a favorable position. There will continue to be price volatility though, not unlike that seen in the commodity space. Monthly gaming revenue numbers from Macau can move the price 10%+ easily. Nonetheless, if the thesis fully plays out, debt restructuring is not out of the question, implying a stock price of less than $1.

SumZero: What key metrics should investors be paying attention to as your thesis matures?

Stanley Wang, Pareto Capital: Key metrics are the following: 1) revenue per customer, 2) capital expenditures by Melco and competitors as percentage of operating cash flow, and 3) overall growth in casino space and other amenities in Macau relative to growth in China GDP.

SumZero: What are the biggest risks associated with the trade in your view?

Stanley Wang, Pareto Capital: The biggest risk is the successful re-stimulus of the Chinese economy through current methods e.g. lending to build skyscrapers. However, each dollar of lending has led to less growth (see current rate cut attempts), and credit-fueled over investment and capacity historically leads to large swings in the other direction (see United States 2008, telecoms in 2000).

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