We haven’t quite finished up our due dilligence, so consider this more of a starter position. If you want to go short, heed this advice, and maybe consider starting with a small size position. AS we continue to dig and provide more research on the name, this will allow for us to hopefully raise our conviction level.
AERL is a holding company for ARGL–which has profit interest agreements with 5 affiliated companies known as VIP gaming promoters (often called junket promoters). VIP promoters work with casinos in Macau to manage VIP Gaming rooms. A VIP gaming room is an individual room within a casino designated for VIP usage only. The VIP promoters are responsible for bringing in wealthy clientele to play in the VIP rooms.
The VIP business is big business in Macau–with nearly 73% of gross revenues (or $24.4 billion) coming from VIP gaming operations (nearly all of it from baccarat). The junket system (or “VIP room system”) emerged in response to restrictive laws and regulations for Macau gaming operators. Prior to 2004, the Macanese government outlawed casinos from granting credit to its customers.
Here’s how the business works—The VIP promoter enters a promotional agreement with a casino, in which the promoter agrees to provide promotional services in exchange for a share of rolling chip turnover or a share of net win percentages —For AERL all of its relationships are based on share of rolling chip turnover. (Macau recently set limits on the commissions paid to a maximum of 1.25%).
The VIP promoters then work with junket agents-who have direct relationships with the gaming patrons and are relied upon by the VIP promoters to bring the clients into the VIP Rooms. The casinos can grant credit to VIP promoters who can in turn extend credit to junket agents, who can then extend credit to the gaming patrons. This seems like a nice workaround to the laws in Macau which restrict lending by the casinos to the patrons.
From our preliminary research we’ve found a things that just seem a bit suspicious:
1. AERL operates as a shell corporation. While it lists 6 subsidiaries under its wings–all that these subs control is a profit sharing agreement with three different VIP gaming promoters—Sang Heng Gaming Corp, King’s Gaming, and Sang Lung Gaming Promotion. Therefore there is no actual operating business here—just a few interest agreements with currently three VIP promoters. Just take a look at a recent piece in the New York Times which discusses a Chinese company called ChinaCast and read this quote closely…
One reason that ChinaCast is having a problem is that shareholders did not actually buy an interest in its operations. Instead, to avoid Chinese restrictions on foreign investment, ChinaCast’s shareholders invested in a United States company that has contractual arrangements with a Chinese company.
2. Junket Business is Sketchy. There have been a lot of stories over the past few years regarding the junket business and its ties to money laundering and organized crime. In March 2011, Reuters published an article citing a U.S. diplomatic cable discussing Mainland China concerns over Macau junkets and VIP operations:
The perception is widespread that, with the implicit assistance of the big ‘junket’ operators, some of these mainlanders are betting with embezzled state money or proceeds from official corruption, and substantial portions of these funds are flowing on to organized crimes groups in mainland China, if not Macau itself
And more recently the International Union of Engineers (IUOE) has made a big push to expose the entire Macau gaming industry. The union launched a website, CasinoLeaks-Macau.com, and posted pages and pages of documents highlighting what it alleges are possible ties between VIP room operators linked to Chinese organized crime and widely known casino brands, including Las Vegas Sands Corp.
3. No Contracts in Place. AERL only has “agreements” that it hopes the junkets will keep. These are not binding contracts by any means. There are according to AERL, 220 gaming promoters in Macau–and ultimately no protection of these interests. Thus far, AERL has seen very little of the cash, profit, or earnings. One thing the agreements do not include is a mechanism by which AERL ever gets access to any of the “profit share.” So far the owners of the junkets have choosen to “reinvest” their profits. Just take a look at the mounting receivables on the balance sheet to get a better look at how AERL is at the mercy of these promoters.
4. Valued as a Fraud. It’s not often that you see ANY company trade at 3 times earnings unless there are significant question marks surrounding the business. I’m sure that shares are presently discounted due to the complicated business structure, the black cloud hanging over the junket industry, a lack of transparency in accounting and no real transparency into any of the subsidiaries (is anyone auditing these promoters? no one really knows). Also there is the whole China fraud discount which I’m guessing is at play here. I can’t pinpoint a fraud at AERL, but based on where the stock is valued, it could provide us with a few clues into what the future might hold.
The one thing that amazes me and maybe scares me a bit is there are four covering sell side analysts with very optimistic opinions on the stock. Janney Montgomery, Stifel Nicolas, Maxim and Stern Agee all have ‘Buy’ Ratings with $11, $12, $12, and $22 targets respectively. It wouldn’t be the first time that the sell side was wrong- but their excessive optimism either tells me that I’m missing something or that they have some sort of Investment Banking relationship with AERL. Still looking into that last part and still digging here.
Again, consider this a low conviction short for now—until we dig further for a few nuggets of gold.