Bad day in New Jersey.  Yesterday was the first super-hot day of the late spring, with temperatures approaching 100 degrees Fahrenheit.  Creaking power infrastructure reacted in the way we’re unfortunately becoming accustomed to.  It collapsed.  No power for most of our neighbors, no internet or cable TV for us.  Hence the late post.

Graff

According to Bloomberg, the plug was pulled on the Graff Diamonds offering less than two days before the stock was supposed to debut.

I can’t say I was shocked, for several reasons:

–Hong Kong has been pummelled especially badly by selling emanating out of the EU, where another flight to safety by equity investors is in full flower.  It looks almost like last summer.  (Where did they get all the stock?)

–Chow Tai Fook Jewellery (HK: 1929) came public late last year and is now trading at about 2/3rds of the IPO price.  True, 1929 sells mainly chuk kam pure gold jewelry and knickknacks, not diamonds.  But the market is the same–China.

–TIF, whose main problems appear to me to be in the US, nevertheless also reported a deceleration in its China business last quarter.

–I suspect that retail investors in Hong Kong–always important in that market–were especially badly burned by the Facebook IPO.  IF US retail investors got 5x-10x what they expected, Hong Kongers could have gotten double that size.  Hong Kong is a market of veteran stock market participants, so they’ll shrug off their bad treatment by underwriters quickly.  But if I’m correct, they’re still licking their wounds.

–I haven’t tried to locate a copy of the Graff Diamonds prospectus.  My experience is that in Hong Kong these documents weigh a ton, but don’t contain anything like that amount of information.  Besides, they’re not supposed to be available in the US until after the offering.  Media reports do bring up two potentially worrying issues, however.

Apparently, a mere 20 customers make up 50% of revenues.

A large chunk of the IPO proceeds were said to be earmarked for buying diamond inventory from the company’s founding family.  I’d want to know how this inventory is being valued–and how many months’ (years?) sales this represents.  I’d also want to know how the acquisition of the gigantic gems Graff is famous for will proceed from now on.  Does the Graff family act as exclusive agent for the company?  …is the family paid a commission for acquisition?

a paucity of demand

When the IPO was pulled, the underwriters had orders for only half the shares intended to be offered by the company.  In a healthy offering the books would be, say, 5x covered.  A “hot” offering might have books 10x covered.  In Hong Kong, which operates under different rules than the US, 100x isn’t unknown.

my thoughts

In the current economic environment, Graff Diamonds was always going to be a tough sell, especially with the family wanting 25x earnings for its shares.  I think FB did much more to suck the life out of this offering than most brokers would be willing to admit, however.

After the New York close last Wednesday, LVS reported results for 1Q12.  Revenues came in at $2.77 billion, up 30.8% year on year.  Adjusted Earnings Before Interest Taxes and Depreciation/Amortization (EBITDA) was $1.07 billion, up 42% yoy.  Adjusted EPS were $.70.  That was a gain of 89.2% over results in the year-ago quarter.  The figure also came in $.01/share above the highest Wall Street estimate, and $.07/share ahead of the consensus.

the details

EBITDA breaks out into:

$456.4 million in Macau, up 20.6% yoy

$472.5 million in Singapore, up 66.1% yoy

$115.8 million in Las Vegas, up 77.9% yoy

$27.5 million in Bethlehem, Pa., up 24.4% yoy.

three unusual items (all in Macau)

The ” adjusted” figures exclude two of the items:

–$51.5 million in pre-opening expenses for the Sands Cotai Central which opened earlier this month, and

–a $42.9 million writeoff of costs linked to the closing of the Zaia show at the Venetian Macau.

Results did, however, include $13 million of costs associated with retailing–management declined to provide any detail.

market reaction

1928 and LVS have dropped about 5% each on the results announcement, despite the obvious strength in the numbers.  I don’t see why.

True, there are some nits to pick, namely:

–LVS is currently keeping 3¢ of every dollar high rollers are betting in Singapore and in Macau.  History says that should be more like 2.85¢, or 5% less.  at some point the company will have a sub-par quarter or two to make up for the current largesse.  But that’s the nature of the casino business.

–There is the mystery $13 million loss in Macau.  But that’s more like a rounding error than a serious dent in operating income.

–EBITDA margins fell qoq in Macau in March.

On the other hand,

–management wasn’t much more incoherent than usual on the conference call that accompanied the announcement

–US operations are much healthier than they were a year ago

–1928 appears to be gaining market share in Macau, even before the new casino opening. Revenues were up 9% qoq, in a basically flat market.

–the mysterious $13 million shortfall in Macau seems to explain all the EBITDA margin deterioration in the SAR vs. 4Q11.  If management is correct in its diagnosis, this is a non-recurring item.  In addition,

LVS is deleveraging   …fast

At December 31, 2010, LVS had $10.1 billion in debt on its balance sheet plus $710.7 million in preferred stock.  Against that, the company had $3.04 billion in unrestricted cash.

As of March 31st, 2012, LVS has accumulated an extra $1 billion in cash.  All the preferred stock has been redeemed and debt is $200 million lower.

That’s about a $2 billion shrinkage in net borrowings.  At the current level of $1 billion in cash generation from operations per quarter, LVS could be completely debt free by June 2013.  (LVS points out that it could be completely debt free today, if it wanted to be, by selling a chunk of its retail space in Macau.)

next stop Spain?

LVS confirmed that it is deep in negotiations with Madrid and Barcelona to develop a huge casino/resort complex in Spain over a decade.  No details as yet.  I wrote about the possible Spanish expansion a little over a year ago.

investment arithmetic

I think that LVS will earn about $3 a share this year.  So at Friday’s closing price, LVS is trading at 18.6x this year’s earnings and yielding 1.7%.

That’s not the right way to value the company, however, in my opinion.  I prefer sum-of-the-parts.

Based on its current market cap in Hong Kong, LVS’s share of 1928 is worth roughly $22.5 billion.  If we think the Marina Bay Sands in Singapore should trade at 80% of 1928′s EBITDA multiple, then it’s worth about $25 billion ($31 billion if MBS were to trade at parity with 1928).

LVS’s market cap (even though it’s up over 30% ytd) is $41 billion.  Therefore, LVS’s US operations are still trading at a value of negative $6.5 billion.

What should the value of Las Vegas + Bethlehem be?

There are, of course, two parts to US profits for LVS–casino operations and management fees collected from Asia.  For simplicity’s sake, lump them together.  Say they’ll generate $600 million in cash from operations this year.  Let’s cut that down to $400 million after taxes.  Now, let’s assume this business never recovers and should be evaluated as if it were a junk bond.  If we assume a that the cash represents a yield of 7.5%, then the principal value of the “bond” should be $5.3 billion.  Subtract $2 billion in debt (that may be excessive, but…) and we’re left with $3.3 billion.

Fair value for LVS, then, should be $3.3 billion + $22.5 billion + $25 billion  =  $50.8 billion, or 24% higher than where the stock is currently trading.

WYNN may be the highest quality casino company, but this analysis means for me that LVS is the most attractive casino stock (remember, I own both LVS and WYNN–more WYNN than LVS, though).

The reason I see for the recent strength in the shares of both Wynn Macau and its parent Wynn Resorts is a press report that 1128 will receive government approval this coming Monday for its proposed new casino in the Cotai section of the SAR.  The news was first published in the Portuguese-language newspaper Jornal Tribuna de Macau and subsequently in Macau Business.

According to MB, the contract signing ceremony will take place while Steve Wynn is in Macau next week, but the official announcement will not come until the contract is published in the Official Gazette in mid-May.

oops!!

Twice before during the past several months, parties associated with WYNN have, prematurely, announced that the company had received approval for the project.  These breaches of protocol appear to have offended the Macau government and resulted in further delay each time.  In the current case, it appears to me that the leak must have come from the government itself, so the article shouldn’t matter.  When questioned about it, Mr. Wynn said nothing, just that he was hopeful of approval but that the decision was up to Macau.

The Wynn Cotai project, whose design was complete over a year ago, will include hotels, casino(s), restaurants, retail and convention/meeting space.  The size of the casino floorspace isn’t clear, although we know the Macau government is eager to see new projects contain a greater percentage of area devoted to non-gambling activities than has been the case to date.  The project will probably end up costing close to US$3 billion.  Opening could be in early 2016.

The Cotai casino would be good for WYNN and 1128…

Cotai, Sheldon Adelson’s idea for recreating the Ls Vegas Strip in Asia, is becoming the hot new gaming location in Macau.  Also, it’s increasingly evident that both Wynn and Encore in Macau are closing in on the limits of their capacity.  So the new project will provide a concrete (no pun intended) path for future earnings growth–both for 1128 and, by implication, for its parent WYNN.

…and for the SAR as well

After all, Steve Wynn is the premier casino designer in the world.  And his company is a master at catering to high roller gamblers.  It would make no sense for the SAR to deprive itself of his expertise.

approval for another firm coming later this year

The government’s overall idea is to continue to expand its tourism business, but at a controlled rate.  It has announced that this means approving two new projects in 2012.

The two prominent other applicants for permission to build a new Cotai casino complex are MGM China and SJM.  If they’re the two finalists, as they probably are, this presents an interesting–and possibly revealing– decision for the SAR.  SJM, the former monopoly casino operator when Macau was a Portuguese colony, which continues to control about a third of the market, is owned by the Ho family.  Pansy Ho also continues to have significant influence over MGM China, where she has about a 20% equity interest.  Declaration of the winner may give some insight into the direction of government gambling policy.

After the close of New York trading yesterday, AAPL reported results for its second fiscal quarter (the company’s fiscal year ends in October).

It was–contrary to highly publicized negative analyst expectations–another litany of record performances.

Revenue was $39.2 billion, up 58.7% year on year.

Net income was $11.6 billion, up 93.3%.

EPS was $12.30, a 92% yoy gain.  Of 42 analyst estimates for the quarter, the lowest was $8.46, the highest $11.80, the median $9.81.  So, once again, AAPL blew away the consensus.

details

The company sold 35.1 million iPhones during the quarter, up 88%.  This compares with 46% growth in the overall smartphone market.

iPad sales were 11.8 million, a 151% yoy increase.

4 million Macs went out the door, up 7% yoy (in a PC market that was up 2%).

iPod unit volume was 7.7 million units, down by 15%.  The music player–which was once half the company–now represents only 3% of sales, however.

what caught my eye

AAPL continues to be capacity constrained with the new iPad.  The huge tablet sales gain this quarter appears to have been driven by demand–especially from schools–for iPad2, once AAPL dropped the price to $399.  I don’t see any reason to think that this new-found new source of tablet demand will go away any time soon.  And it could turn out to be very big.

Greater China was the geographical star.  Sales in the region, which made up 20% of the AAPL total for the quarter, tripled yoy.  iPhone sales were 5x the year-ago level.

Mac sales barely outpaced the market for the quarter.  But that’s comparing a newly refreshed product line a year ago with the same lineup today–now a little long in the tooth.  So I don’t think the weaker than usual comparison means anything.

Management gave its usual song and dance to “justify” its low-ball earnings estimate for the June quarter–$8.68/ share.  The company did make two reasonable points, though.  It expects to sell a lot of iPads, which carry lower margins than other AAPL products.  Also, 2+ million of the iPhones sold to telephone companies during the period went to replenish store inventories depleted during the holiday season.  This extra demand won’t be present in the current quarter.  Neither is that significant, in my opinion.  Together, they may just mean that yoy gains in 3Q12 won’t be quite as impressive as in 2Q12.

pre-announcement analyst panic

AAPL sold off by about 15% in the days before the earnings release.

I was struck by the number of analysts who rushed to publicly validate the price decline by offering negative assessments (now proven to have been wildly incorrect) of the company’s 2Q12 prospects.  One can only imagine what they were saying in private meetings with institutional clients.  I was also struck by the dearth of AAPL defenders–although it’s possible their comments were edited out.

For instance,:

–one analyst I read predicted Mac sales would be down, year on year, in the quarter–without mentioning either how difficult the comparison was or that Macs only make up a bit more than 10% of AAPL’s business.

–another said in a recent TV interview that he was lowering his forecast of iPhone sales from 33 million to 30 million–and intimated he thought that figure might still be too high.

I have four observations:

1.  I think the analysts in question extrapolated from what they knew about the US and Europe to the rest of the world.  When you think about it, that seems kind of loony.  Why would you think China, which is growing at 7%+ and where people are just starting to buy smartphones, would look like the US?

2.  More generally, the incident says something about the quality of research on Wall Street.  APPL isn’t the only case.  Analysts did the same sort of extrapolation with INTC last year.

3.  It says something admirable about AAPL that they don’t have one standard of information dissemination for ordinary people like you and me, and another one for Wall Street analysts.

4.  This shows how a rumor-driven market works.  Once a story starts, information sources rush to repeat and amplify the rumors, mostly because they’re worried that otherwise they’ll be thought to be out of touch.

AAPL’s stock?  It still looks cheap to me.

On Monday April 2, the Macau Gaming Inspection and Coordination Bureau published on its website monthly results for March in the SAR.  Here they are:

Source: Macau DICJ (Gaming Inspection and Coordination Bureau)

what they say to me

Yes, it’s the strongest non-holiday month ever in Macau.  Only last October (with Golden Week) and this January (New Year) had higher monthly win for the casino industry.

On the other hand, we don’t see anything like the almost manic surge in the size of the market that we experienced throughout 2011.  We may see some upward bounce in the April and May figures, as the new Las Vegas Sands casino on Cotai opens this month.

There isn’t enough evidence yet to draw firm conclusions.  However, if the right way to read the current figures is that the market is plateauing for the moment around the MOP 25 billion level (this is my guess), year on year growth comparisons should begin to narrow as the second half starts.

Although, again, there’s no clear evidence, I’m reading this potential growth slowdown to be the result of economic slowdown on the mainland.  If so, as the current expansionary measures Beijing is enacting bear fruit, I’d expect the growth rate to begin to expand again.  Timing is the only question.

It’s possible, though, that the plateauing I see is being induced by the leading casinos having reached full capacity–in which case, second-choice casinos should enjoy their day in the sun over the coming months.  And the Macau government should accelerate the pace of its approval of new casino permits.

One other point:  prior to the mammoth overcapacity the Las Vegas casinos by aggressive new construction during the past five years, only about half of that industry’s profits came from gambling.  The rest was food, lodging and entertainment.  One would expect that at least the American-owned casinos would follow the same development model in Macau–a move the Macau government is strongly encouraging.

Over the next five years, then, one could expect the gambling market to grow by at least the rate of Chinese GDP, or by close to 50%, and the industry’s profits to expand by a minimum of another 50%–and maybe much more–as non-gambling businesses expand.

Over the next five months, on the other hand it’s less clear how much there will be to cheer about.  I don’t see any need to sell the stocks;  I just don’t think they’ll run away to the upside.

In Hong Kong trading Tuesday, the major Macau gambling stocks moved sharply upward.  Wynn Macau, a recent market laggard, was the star, gaining 8.6%.  But even China Sands, which is up by over 40% since the Hang Seng peaked last August, rose by almost 6%.

Why?

the Karen Tang effect

According to Bloomberg, Karen Tang, a prominent Hong Kong-based leisure analyst who works at Deutsche Bank, reversed her relatively negative view on casinos in the SAR after meeting with company managements.

Ms. Tang sent these same stocks into a tailspin last August.  That’s when she issued a report arguing that a falloff in demand for high-end luxury cars that was then being experienced in China presaged an almost complete evaporation of growth in the VIP baccarat market in Macau.  Since high-stakes baccarat is the mainstay of the casinos there, this was an especially dire forecast.

Her idea was that the market would begin to slow in the autumn.  Economizing high rollers would make trips already planned–and possibly paid for–but wouldn’t book further visits.  The market wouldn’t contract.  But growth would nosedive, troughing late in the first half of 2012 at a year-on-year rate of, say, +15%, before beginning to rebound.

too pessimistic

I didn’t see the Tang report.  But it was extensively covered in the Asian press.  From those accounts, it seemed the evidence was flimsy and the conclusion much too pessimistic.  As it turns out, Ms. Tang was wrong.  That’s not the important thing (although I’ve been unable to refrain from inserting this conclusion in this post).

rebound already!

What is important is that after a mild slowdown to a “mere” 25% growth rate last December, Chinese high roller gambling in Macau is beginning to accelerate again.  That’s what Ms.Tang found out on her research trip to Macau and published in a note yesterday.

While I was looking at yesterday’s stock prices in Hong Kong while writing this post, I noticed an article from Forbes.com.  It reports the results of a research trip to Macau by a Citibank (never to be mistaken for a research powerhouse) analyst, who says the casinos indicate gambling in the SAR grew by about 40% year on year during the first 11 days of March. That’s substantially ahead of the 28% year on year growth of the market during January-February.  And it’s not that far below the 42% gain the market put up for full-year 2011.

According to Forbes, Nomura Securities (which makes Citi look good) thinks March gaming win will be up by about the same rate as the average of January/February (a two month average corrects for variable timing of the New Year holiday).

The bottom line, though, is that the market is a lot better than the consensus had thought–and is looking up.

stock market implications

casino stocks?…

Given all the lawsuits flying around, this may not be the time to load up on the Las Vegas gambling companies.  Personally, the litigation bothers me enough that I won’t buy more, but not enough to sell what I have.  It seems to me that the Macau subsidiaries are relatively insulated.  I like Steve Wynn.  And Las Vegas Sands is still cheap.

…or indirect plays?

The most important aspect of yesterday’s trading may be the signal that corporate magnates in China are starting to feel a lot better about themselves and their businesses.  The safer way to go is probably to look for sold-off US firms that have a lot of Chinese exposure.

LVS reported 4Q11 and full-year 2011 results after the close of New York trading on Thursday February 1st.  Quarterly revenue for the company was $2.3 billion, up 26.3% year on year.  Net income was $460.9 million, or $.57 a share.  That was up 38% year on year.  EPS exceeded the average analyst estimate by about $.03.

For 2011 as a whole, LVS posted $9.4 billion in revenue, up by 37% from the %6.9 billion taken in in 2010.  EPS more than doubled to $2.02 vs. $.98 in the prior year.

details

Sands China in Macau took in $1.33 billion in revenue during 4Q11.  Ebitda (earnings before interest, taxes, depreciation and amortization) was $430.1 million.  These figures were up 22% and 29% year on year, respectively.  3Q11 ebitda was $388.3 million, meaning 4Q results were up 10.7% qonq.

Marina Sands in Singapore had revenues of $806.9 million for the quarter and ebitda of $426.9 million, aided by an unusually high win percentage at table games.  These were yoy increases of 44% and 40%.  3Q11 ebida was $413.9 million, so the qonq gain was 3%.

Las Vegas operations had revenues of $339.5 million and ebitda of $80.9 million.  Revenue was up 9% yoy, ebitda was about flat.  3Q11 ebitda was $94.3 million.  Qonq, 4Q ebitda was down 16%.

my thoughts

earnings

Let’s assume US operations will be flat year on year in 2012, ex management fees from Singapore and Macau.  I think there will be some small gains, but the main issue is not the economy.  It’s the severe overcapcacity of hotel rooms and gambling space in Las Vegas.  Dividends from Sands China will probably add close to $1 billion–covering the parent’s dividend payout.

HK: 1928 will soon be opening the first phase of its newest Macau casino, Macau Cotai Central, shortly.  In a market that will likely expand by 25% this year, 1928 will likely easily grow by 30%–probably considerably more.

I don’t know any good way to estimate growth for the MS Singapore.  The casino hasn’t been open that long, for one thing.  For another, after posting continuous increases in ebitda since opening, income seems to have flattened out in 4Q11.  Is this seasonal?  …or something else?   No one knows.  If we assume no organic growth but that the casino continues to generate revenue at the 4Q11 rate throughout 2012, ebitda would grow by 15% yoy.

Repayment and restructuring of debt at lower interest rates will chip in, as well.

Put all this together and I think the analysts’ consensus of $2.50 in eps for this year is a reasonable guess.  We’ll be able to tell more when the official year-end financials are published.

asset value

At today’s level, the market value of LVS is about $38 billion.

Its ownership interest in publicly traded Sands China (1928:HK) is worth around $21 billion.

If we assume that wholly-owned Marina Sands should be valued at 80% of 1928′s ebitda multiple–because of less clear near-term growth prospects–then MS is worth $24 billion.

If so, Macau and Singapore are together worth $7 billion more than the market cap of LVS–implying that, in the mind of Wall Street, the $424 million in annual US ebitda subtracts a ton of value.  That’s silly.  LVS would need to rise above $60 a share in order for the stock price to reflect no value for the US operations.

dividend

Both LVS and 1928 have declared initial dividends and signaled their intention to sustain them at at least the current level.  LVS will be paying $1 a share annually, meaning a yield of slightly below 2%.  1928 will be paying HK$1.16, a 4% yield.

Three implications:

–dividends are supposed to be paid from profits.  Both LVS and 1928 are saying they expect to remain at least as profitable as they are now.

–both companies believe they’ll be generating enough free cash flow to sustain the payout

–the companies’ lenders (LVS has about $10 billion in debt) are satisfied that they’ll be repaid and have okayed the dividends.

conclusions

LVS  isn’t the best casino operator in the world.  That’s WYNN, in my opinion.  But at the moment I think it’s the best casino stock.

Management is highly competent.  And the company is nearing the end of a very ambitious (read: risky) multi-year, multi-billion dollar Asian expansion.  The financial crisis came at the worst possible time for LVS.  Nevertheless, the company has completed its plans.  It’s now entering a period of potentially immense free cash flow generation that will transform the financial structure of the firm over the next two or three years.  I don’t think Wall Street has worked this out yet, as shown by the undervaluation of LVS on a sum-of-the-parts basis.

In assessing China, I think it’s important to distinguish carefully between the course of the mainland Chinese economy and the fortunes of China-related stocks.

the economy

background

The foremost goal of the Beijing government is to keep the ruling Communist Party in power.  This translates into the economic objective of avoiding possible social unrest by keeping employment high and unemployment low.  That’s quite a trick when you’re managing the transition from a rural, agriculture-based society to a more urban and manufacturing-oriented one.

In addition, China dedicated itself to creating a Western-style market-based economy in the late 1970s when it realized the country was too complex for central planning to work.  Again, hard to do when three-quarters of your industrial base was zombie-like state-owned corporations, when being a businessman was a felony and where citizens preferred to bury chuk kam gold trinkets in the back yard rather than use banks.

Complicating the situation further is the fact that high corporate or local/national government officials are Party officials whose chances for personal promotion are directly related to aggressively growing the areas they control, whether doing so makes long-term economic sense or not.

results

At the same time, all the mid-level national economic officials I’ve met–who actually implement policy–have been highly sophisticated, well-trained (mostly from the US or UK), competent and dedicated to creating healthy and balanced growth.

Given the large size of the Chinese economy and the paucity of tools to make economic policy, the best they’ve been able to do is to lurch between two extremes, overheating and stalling (the latter meaning unemployment is rising–a combination of new entrants to the labor force and layoffs)–and gradually lessen the amplitude of the cyclical swings.

where we are now

When the developed world appeared to be coming apart at the seams in 2008, China allowed a particularly strong domestic lurch to the upside.  For the past two years or so, Beijing has been trying to force an economic slowdown to rein in that expansionary impulse.

Policymakers have most recently been signalling their belief that slowdown has gone far enough and it’s time for faster expansion again.

China stocks

By and large, non-citizens can’t buy or sell stocks in the domestic market.  I’m not sure it makes much economic difference whether the local bourses go up or down.

Hong Kong is the natural market where the best and brightest of the mainland list their shares.

Over the past six months, Hong Kong stocks have sold off much more heavily than, say, the S&P 500, in response to worries about the Eurozone and potential global economic slowdown.  Since bottoming in early October, they’ve only rallied back in line with the S&P.  As I see it, so far there’s no anticipation of a better mainland economy this year in Hong Kong stock prices.  Many stocks there look cheap to me.

what to do

Personally, I think it’s important for all but the most risk-averse investors to have some exposure to the Chinese economy.

The most conservative way to do so is to hold companies listed in the US or Europe that have significant businesses in China.  Luxury goods retailers like LVMH, Tiffany or Coach are possibilities.  Casino companies like Wynn and Las Vegas Sands make all their money in Asia.

Discount brokers like Fidelity offer international trading services that allow foreigners to buy stocks in Hong Kong directly and cheaply.  Most investors will likely find it easier not to do research themselves, however, and buy an ETF or an actively managed mutual fund that specializes in Hong Kong or Greater China.

Price action in December and early January is often hard to read because of tax-related selling–losers in December, winners in early January.  Still, I’ve been a bit surprised that Hong Kong stocks haven’t done better than they have, given that the most recent economic news out of China, the EU and the US has virtually all been positive.

I don’t think this means that the positive case for the Chinese economy and for Hong Kong stocks is incorrect.  It may just take more time for negative emotion–from investors located in Europe, I think–to exhaust itself.  I’ve always thought that “buy on weakness” is pretty lame advice.  But it’s probably the right approach in this case.

I didn’t know until I was reading the Wall Street Journal this morning that Hong Kong had depository receipts (DRs).  But COH just issued one.

Sure enough, checking with the Hong Kong Stock Exchange website, HDRs have been permitted in that market since mid-2008.  Not many takers so far, however.  The HKSE lists Vale, the Brazilian iron ore company, with two HDRs; SBI, a Japanese internet-based financial, has one.  And now there’s COH (6388 is the Hong Kong ticker symbol).

what they are

The basic idea behind a DR is to provide a simple way for a domestic investor to buy a foreign stock without having to set up a brokerage account in the foreign country or to deal with foreign exchange, either in buying and selling or in receiving dividends.

The buyer doesn’t actually get a share of stock, however.  Instead, he gets an IOU (the receipt) from some financial entity, usually a bank, that holds the real shares in a depository account.  The bank handles all the necessary administrative details, like foreign exchange and the sometimes messy business of meeting the foreign country’s securities and tax regulations.

ADRs

The company whose stock underlies the DR may use the DR issuance to raise capital in a new market, where investors may well pay a higher multiple for shares than would be possible in the home market.  In the biggest DR market, the US, I’ve found this often the case–and regard it as a bad sign.  In my experience, seeing a mature company launch an ADR means it has lost its allure for more knowledgeable home market investors.  (Another important factor in ADR issuance in particular is that it circumvents the more stringent disclosure and reporting requirements that the SEC has for US-based companies.)

In the COH case, however, the firm has not created 6388 to raise new funds–after all, operations are generating $1 billion in annual net cash.  It has created a DR to raise its public profile in Greater China.

their Achilles heel

The bane of DRs, in my opinion, is low trading volume and potentially Grand Canyon-wide bid-asked spreads.  I’ve found the problem especially acute in cases, like this one, where the operating hours of the home and DR exchanges don’t overlap.  According to the HKSE website, trading in 6388 over the past five days has only totaled about US$11,000.  The bid-asked spread shown is about 2% (my experience in the US is that the spread for a stock like this could be more like 10%).  December is usually a dreary month for investors, so January will probably give a better read on volume.

worth watching

Nevertheless, COH has probably gotten more publicity in China through the HDR listing than it would have been able to buy with the money it spent to create its HDR.  The phenomenon itself it worth watching, as well.   Two reasons:

–we may ultimately reach a tipping point where having a HDR acquires a cachet that exerts a positive influence on the home market security price, and

–pioneers like COH may have a leg up on obtaining an eventual listing on a mainland exchange.

Macau gaming stocks began a late-August swoon when Karen Tang of Deutsche Bank, an influential securities analyst in the Hong Kong market, published a report on the casino stocks there.  In it, she predicted that a sharp and protracted slowdown in spending by high-rollers in the Macau gambling market would soon begin.  According to Reuters, she said that revenue growth would slow to +34% year on year in October 2011, +32% in November and +20% in December. Growth might shrink to as little as +10% during 2012.

her reasoning?

Affluent Chinese were no longer spending on European-made luxury cars.  She and the DB economics department felt that this was the harbinger of a widespread pullback in consumption by the wealthy.  Finally, they thought, the affluent were succumbing to the Beijing government’s attempts to rein in economic growth on the mainland.

does the argument make sense? 

In my opinion, no.   There’s been no sign of falloff in any other area of Chinese luxury spending.  Maybe the new cars were ugly, or the potential buyers had no garage space left.  I’m not saying that Chinese gamblers aren’t going to spend less in Macau in the coming months.  That could happen.  I’m only observing that I don’t think the luxury car situation is evidence in favor of this conclusion.

I think Ms. Tang would have been better off arguing that the Macau casino stocks were fully priced for the best possible outcome and therefore had no near-term upside.  That would mean that they could only go sideways or down–reason enough to take some profit in the sector.

Nevertheless, the Tang report was enough to drive the sector down very sharply in late August and throughout September.  At one point, some stocks had lost close to half their value before beginning to rebound.  …and then the Europe-related selling began.

what does all this mean for us today?

Well, the November Macau gambling market results were posted on the website of the Macau Gaming Inspection and Coordination Bureau on the afternoon of December 1st.  Here they are:

Source: Macau DICJ

As you can see from the bold figures, after being wildly wrong about October growth prospects, Ms. Tang seems to have predicted the November results reasonably accurately.

Is there any significance to the November prediction?  My guess is that there isn’t much meaning for the stock market, even if this turns out to be more than a lucky guess.  For one thing, the stocks are much cheaper today than they were when the original report came out.  For another, Beijing has just publicly signaled that it is reversing its money policy to favor GDP growth.  So stocks should now be beginning to discount a reacceleration of the gambling business in Macau–not a slowdown.

It will be interesting to see how the Hong Kong market evaluates this situation.  My hunch is that the mid-November lows will hold, but that the market will want to see at least the December market results before becoming more bullish.