Melco (MLCO) Stock: For Those With A Penchant For Living On The Edge

Thesis

The economic ramifications of the global pandemic, particularly for establishments such as Melco Resorts (NASDAQ:MLCO), have been intense. The organization is heavily reliant on the draw of Macao’s bustling gambling scene as a major source of tourism and income—but with visitor numbers crashing in line with harsh travel restrictions, it is easy to see why Macao failed to hold up its tradition as the go-to destination for gamblers around the world.

This has had serious implications for Melco’s overall financial performance in recent times, which are unquestionably shocking given the impact to not just Asia but worldwide tourist hotspots such as Las Vegas. Despite Macao slowly coming out of the other side of COVID-19 and showing signs of recovery, further effort is needed in order to recoup some semblance of what it enjoyed prior to the crisis, which may never come.

Melco Resorts has seen a slight increase in its performance in the past year and is outperforming the S&P 500 index. On the surface, this would make it appear to be a worthwhile investment. Still, on closer examination, it’s clear that due to regulatory unpredictability and poor financial performance, investing in Melco Resorts may not be prudent in the long run. Unpredictable regulations have already caused difficulty for gambling corporations operating in China, and poor financial fundamentals mean that the future success of the company is highly uncertain. Therefore, investors may want to give pause before taking a chance on this financially troubled gambling corporation.

The Bright Side

Long-term investors might view Melco Resorts’ presence in Macao as presenting an invaluable business opportunity, as it holds one of only six casino license concessions in a region where gambling is a legal activity. Macao’s neighboring area presents a wealth of potential for economic growth due to the low current market share, as well as rising disposable incomes in both rural and urban households. This demonstrates the latent demand for such services in greater China, whose continued growth over the course of the coming decade could potentially enable Melco to capture a larger share of this valuable market. Consequently, some investors are confident that holding a casino license in Macao will be of tremendous benefit and give them an edge over competitors.

Furthermore, Melco’s latest Project Phase (Studio City) Two is an indication of the company’s growing focus on the nongaming business. As part of this project, Melco has introduced various non-gaming attractions such as 900 hotel resort rooms, a 24-hour indoor and outdoor water park, stylish meeting rooms for events and conferences (MICE), and other features to bring in customers outside of gambling. This strategy caters to the Macao government’s vision of diversifying the economy with more accessible tourism options. The unique benefits that come with non-gaming sources such as MICE events guarantee stable revenue streams even during slow seasons, allowing Melco to maintain normalized returns throughout their business cycle backed by the promise of their intangible assets.

And finally, mainland China’s abrupt reversal of its stringent zero-COVID-19 policy is met with much relief by those affected by its effects on business. The recent adjustment brings more hope to companies operating in mainland China, such as Melco, which depends heavily on the nation for 89% of its visitor traffic. This change dictates a shift from attempting to completely control the virus towards adopting countermeasures and treatments that would enable adaptation to its presence. The benefit of this transition towards ameliorated policy results in falling levels of restrictions imposed on business operations, allowing companies to regain the momentum that had been greatly damaged due to previous regulations regarding the entry and stay in the country.

The Macao government has taken two vital steps toward the normalization of the area in the past few months. First, a resumption of e-visa travel to Macao was announced for November this year, enabling visitors from mainland China and Hong Kong to resume travel more freely. Second, changes have been made to existing guidelines and restrictions on controlling COVID-19, which further reduces the risks associated with mobility. And compared to previous strains, the current severity of omicron is lower meaning that with sustained efforts on increasing vaccination rates across China there may be scope for further easing of these restrictions, providing an optimistic outlook for recovery in the foreseeable future.

Major Potential Pitfalls

Melco International’s declining income of $241.8 million is highly concerning, as it indicates a stark 46% decline from the previous year. This devastating financial downturn can be largely ascribed to the travel restrictions implemented by China and the subsequent closure of Macao resorts by the Chinese Government in July. While Melco’s immediate prospects are bleak, their long-term situation does not appear particularly promising either. With the tourism industry experiencing intense disruption on a global scale, this could mean a prolonged period of financial hardship for the company and its shareholders – a rather disconcerting reality in these uncertain times. The last three years have seen a dramatic deterioration in the company’s financial health. With long-term debt of $7.73 billion and only $1.52 billion in cash, much of which will soon be consumed in repayment of the leverage, their level of indebtedness is staggering. To add to that, 94 million was spent on interest payments alone over that time frame – an exorbitant amount for any business or institution. Unless drastic changes are made, this level of debt servicing could become unsustainable very quickly.

It is almost impossible to expect that the Chinese central government would ever approve of gambling being legalized in any other cities across mainland China, due to their desire for keeping the activity contained within Macao. Allowing gambling to expand into another territory would inevitably result in revenue from the casinos in Macao dipping dramatically. This could, in turn, compromise Macao’s position as the specialized casino jurisdiction of Eastern Asia and undo years of investment, establishing its allure as an East Asian version of Las Vegas. Although there is always a possibility that policy enactments defy all expectations, it still remains highly unlikely that any decision outside of maintaining the status quo will be reached by the Chinese central government. Nevertheless, the Chinese central government can be unpredictable.

Despite the limited concession period that allows only a medium-term outlook on casinos in Macau, these gaming hubs will continue to operate under a monopoly of sorts, likely for at least the next ten years. Despite this knowledge, considering the gaming industry could be subject to increased regulation in the years ahead, investing large sums of money into such an endeavor might not be completely prudent.

Takeaway

With the government’s continuing involvement in the gambling industry, there is a strong likelihood that Melco Resorts will face stringent renewal requirements. Moreover, as the local and Macao casinos expand their operations into Asia’s gaming landscape, the competition among them for premium segment customers will likely be amplified. Thus, Melco may need to divert additional resources to appeal to and entice this tier of customers, particularly if they wish to remain competitive in the sector. All signs point toward increased expenses on their behalf as they attempt to abide by regulatory expectations while also gaining larger shares of the market.

Moreover, the signs of the Coronavirus pandemic are still lingering in our global context, leading to more disruption for many companies. Macao casino players, in particular, with their high price-to-sales (P/S) ratio, have felt the brunt of this disastrous situation. Melco Resorts’ P/S ratio currently stands at 3.8, much higher than the S&P 500 Index average of 2.3. When taking into account their continuously declining revenues and precarious balance sheet compared to others in the same market, it may indeed be too pricey a value to justify based on current conditions and future expectations. Overall, the COVID-19-induced headwinds, along with travel restrictions, create an element of uncertainty that could be challenging for Melco Resorts going forward.