Melco Resorts & Entertainment: Highly Levered With Weak Coverage (NASDAQ:MLCO)

Investment Thesis

Melco Resorts & Entertainment Ltd. (NASDAQ:MLCO) is a company that develops and manages resort sites. The business runs casinos in both Macau and the Philippines. Over the last year, the company registered a strong share growth of about 127% and a solid shareholder return. I attribute these good results to the easing of Covid 19 restrictions which boosted gambling and the growing casino market.

Despite these good results, given its debt burden and the looming recession, I am skeptical about the company’s future. I believe these two aspects overshadow the optimism underlying the growing casino market.

Quite a Profitable Year for Investors

Buying an index fund these days is simple, and your returns should roughly track the market. However, investors can increase their returns by investing in market-beating companies. MLCO’s share price is 127.61% higher than it was a year ago, outperforming the market median of roughly 16.85%. Investors will do extremely well if it can sustain its outperformance over the long run! On the other hand, long-term returns are negative because the share price is about 54% lower than five years ago, raising concerns about the sustainability of the solid return last year over the long-run.

Let’s check in on the company’s long-term fundamentals to see if they square up with the results investors have seen. Since the company has not turned a profit in the past year, I will examine the expansion of its top line to get a sense of its health. Companies that are making losses year after year should increase their sales rapidly. Fast sales growth, if sustained, usually results in correspondingly rapid expansion in profits.

Compared to the previous year, MLCO’s revenue is down 19.15%. Despite the decline in sales, the stock price soared by around 127% over that time. The increase in the stock price is not consistent with the company’s growing revenue or profits, but it appears the market had anticipated weaker results; thus, investor sentiment could be rising.

It’s pleasant to note that MLCO shareholders enjoyed a total shareholder return of roughly 127% during the past year. Although the long-term decline has made me wary, the recent uptick in TSR suggests a brighter future. Although the effects of market conditions on the share price are important to think about, there are other factors to consider, some of which I will cover in my analysis.

A Growing Market: A Potential Sales Catalyst

A compound annual growth rate of 4.86% is projected for the casino gaming industry from 2022 to 2027. It is anticipated that the market will grow by $65.63 billion. Several reasons, including rising consumer disposable income, widespread adoption of internet casinos, and rising interest in gambling generally, will contribute to the market’s expansion.

The casino gaming sector is growing due to customer spending ability. The rise in dual-income households explains the world’s high disposable income per capita. This has made high-end services like casino games more affordable, raising developed countries’ purchasing power. Working women worldwide have also increased. Higher incomes will allow people to spend more on sports betting and other leisure activities. High-income individuals use it as a status symbol.

Due to the expansion of game types in recent years, the demand for casino games has been on the rise. Online casino games were despised because they were cheap, obscure, and risky. However, the market is anticipated to experience considerable expansion over the course of the projected period due to rising revenue levels and increased provider investment in online platform security.

A significant factor impacting the expansion of the casino gaming sector is the rising usage of social media marketing. Online and offline casinos employ social media marketing techniques to draw clients. Social media sites like Facebook, Instagram, and Twitter are growing globally due to the proliferation of smartphones and better internet connectivity. Providers use cutting-edge marketing techniques to advertise gaming activities and casinos since they recognize the influence of these social media platforms.

Given these promising market trends, I expect MLCO to grow its market share and expand its revenue base as the market is projected to grow. In my view, this gives us a reason to hope for better top and eventually bottom line if the company leverages this growing market. I think the company is trying to align itself in the growing market by exploiting development initiatives. For instance, in the MRQ, they launched Studio City Phase 2 with the opening of the Epic hotel tower and the indoor water park, beginning the first-ever series of residency concerts in Macau. In order to complete their hotel portfolio in Macau, they also want to open the W Hotel tower in September.

The Debt Situation

The main investing risk is not volatile prices but the possibility of irreversible money loss. Since excessive debt can result in ruin, I always want to consider a company’s debt usage when assessing its risk.

MLCO has a total debt of $8.2b. However, it does have $1.3b in cash offsetting this, leading to net debt of about $6.8b. According to the most recent balance sheet data, MLCO has $867.7 million in short-term liabilities and $7.77 billion in long-term liabilities. To compensate, it has $1.3 billion in cash and $69.7 million in receivables. As a result, its liabilities exceed the total of its cash and receivables by $ 7.26 billion. The shortfall here weighs heavily on the company’s $ 5.57 billion market cap. In the end, if its creditors demanded repayment, the company would likely require a significant re-capitalization which could lead to massive dilution.

Besides the high debt, the most significant is whether the company can service its debt. To establish these, let’s look at the company’s interest coverage by EBIT and cash flow availability on a TTM basis. With an EBIT loss of $584.2m, MLCO’s earnings are not adequate to cover its interest expense of $398.6m. Additionally, since accounting profits can’t be looked at in exclusion to pay off debt, cash flows are an important aspect in debt payment. As if the lack of interest coverage was insufficient, the company has a levered free cash flow balance of -871.11m.

Guided by this data, it is apparent that this company is a risky investment because apart from its debt being high, the company is unable to cover it, and thus the risk of defaulting is high.

A Looming Recession

Economic experts are growing less optimistic that the much-discussed recession of 2023 will actually occur. The economists at Wells Fargo are the most recent experts to downgrade their expectations of a recession this year. According to the company, a recession will start at the beginning of 2024.

People are debating the recession as they wait to see how the economy will respond to the Federal Reserve’s 40-year-old most aggressive interest rate hike campaign. A “soft landing,” in which the US economy only marginally slows down, or a “hard landing,” where the Fed causes a severe recession and high unemployment, are two possible ways for the economy to recover from the interest rate hikes.

The Nasdaq is up almost 26% this year, while the S&P 500 is almost in a bull market. The stock market is seen as a forward-looking indicator. Therefore, markets aren’t factoring in a severe recession if it still happens in 2023. What this means is should it happen, investors should brace for losses as the recent prices seem not to factor in a potential recession in 2023.

For MLCO, the possibility of a recession, whether it starts this year or at the beginning of next year, is not desirable. This is due to the company’s ongoing struggles with profitability and impending insolvency caused by its huge debt load and weak financial foundation for repaying the debt.

My Final Thoughts

Much as I can see some optimism in the growing industry, I think this optimism is being overshadowed by the looming recession, which will add to what I can term a financial crisis in this company, given its high debt load and poor profitability. From where I stand, I rate the company a hold until the economic uncertainty subsidizes and until the company improves its financial footing. To the more cautious investors, I think now could be an early exit before more crises arise.