Source: Melco Crown Entertainment

We are closing out our bullish call on Melco Resorts & Entertainment (MLCO) and are moving to a neutral posture.  Since we made our bullish call on MLCO 2 months ago, the stock has appreciated from $16.06 to a recent price of $21.70, for a gain of about 35%.  While we still believe the bullish fundamental arguments for MLCO shares we laid out in the article, we believe that these arguments are now widely understood and accepted by market participants.  Specifically, we believe that investors now understand the significant benefit that the launch of VIP gaming at Studio City represents for the company’s operating results.  As a result, we no longer believe that MLCO will outperform its peers in Macau going forward, and see more attractive risk-rewards elsewhere. 

To be clear, we would be shocked if MLCO reported anything but a spectacular first quarter next week.  As we explained in detail in our article in early March, the company’s results likely benefited both from strong overall Macau trends, as well as company-specific events including the Suncity “Night of Legends” event at Studio City.  This exceptional first quarter could, however, be the high water mark for MLCO’s relative performance for a while.  Put differently, it will be difficult for the company to top the success of some unique events in 1Q17 in upcoming quarters. 

If anything, the fight for market share in Macau may get slightly more intense going into the seasonally slower summer months.  This could relatively favor other operators with stronger competitive positioning in specific market segments, namely Wynn Resorts (WYNN) in VIP and Las Vegas Sands (LVS) in the mass market.  Moreover, MLCO will have to contend with the upcoming openings of MGM Cotai and Lisboa Palace.  As strong 1Q17 results move into the rear view mirror, we believe that investors will likely focus to an increasing extent on these plausible headwinds.  In turn, we believe that MLCO’s recent strong run of outperformance may not last.

How could we be wrong?

We have to admit that we could be wrong on this call.  First, we could be early.  It is clearly possible that the stock continues to appreciate ahead of earnings next week.  Secondly, we continue to see signs that MLCO’s management team is executing well in Macau.  For instance, Studio City is one of only three stops on the recently launched “Cotai Express” shuttle bus service (along with Venetian and Galaxy).  It is impressive that MLCO management beat many peers in this respect.  It is possible that management execution will continue to overcome some of the structural disadvantages of the Studio City location, and drive better results than we currently expect.  We are implicitly making a call here that investors have already given management credit for this improved execution, but we could be early here as well.

What does this mean for Macau broadly?

We want to be clear that this does not represent a change in our long-term views on the Macau market.  We continue to be long-term bulls on Macau, for all the reasons first described in our in-depth article in January.  If anything, the numbers out of Macau have been stronger than we originally expected.  Our most recent visit to the Macau market confirmed what the numbers have shown, namely that the recovery continues to gain traction.  This market strength was the key reason that we let our bullish recommendation on MLCO run longer, and to a higher share price, than we originally anticipated.  It is also the reason that we are still either bullish or neutral on all the Macau operators (with no outright bearish views).

We also stick by our recommendation to be selective in the Macau names, however.  In spite of overall strong trends in Macau, there has been significant dispersion in share price performance between different operators this year.  For instance, at the time of this writing WYNN and MLCO are both up more than 45% year-to-date, while LVS is only up about 11%.  We believe that opportunities for meaningful relative outperformance will continue to exist for gaming investors, but likely in different stocks.  As we have explained, we no longer view MLCO as a likely outperformer at this time.  Other adjustments to our stance may become appropriate in the coming days and weeks.

We also remind investors that in spite of the long-term uptrend we see in Macau, volatility tends to hit when you least expect it.  Disappointing monthly revenue releases for December 2016 and January 2017 caused investors considerable pain not too long ago.  And these came right on the heels of a very strong November 2016 report.  We have yet to meet anyone who can reliably predict these monthly results.  In light of the higher expectations for the market generally, it may not be a terrible time to build a little dry powder with any gains from MLCO.