Editor's note: "Bricks and Mortar" is a mock portfolio created by reporter Nicholas Yulico that is meant to help generate real estate and gaming-related stock ideas. In keeping with TSC's editorial policy, Yulico doesn't own or short individual stocks.

Melco PBL's ( MPEL) attempts to dominate the VIP segment of the booming Macau casino market have taken a positive turn.

Yet, for all the supposed good news, the stock is stuck in neutral, trading at levels seen six months ago. Once again, the word is "manana." I can't help but wonder: How long will long-term investors stick around?

I've been bullish on Melco since March, when I rated the stock own and included it in the Bricks and Mortar mock portfolio. At the time, many investors had given up on the name -- as did our own Jim Cramer.

My thesis was that Melco shares were priced at an attractive entry point since the company's casino development pipeline would eventually pay off handily, rewarding investors. (As a reminder, Melco is the only pure play on the Macau casino market.)

Since my initial rating, the stock has been a huge disappointment. Shares closed Wednesday at $13.27, down about 15% since I recommended the stock at $15.50. Over the same time period, fellow Macau casino owners Las Vegas Sands ( LVS) and Wynn Resorts ( WYNN) are up about 30% each.

In May, Melco opened its first casino, Crown Macau, which is focused on VIP gambling. Results have been disappointing, and management has done a poor job of executing. All along, I've given the company the benefit of the doubt.

In the third quarter, Melco reported its first full quarter of data for Crown. While revenue was decent at $98 million, the casino posted a loss, hurting from a high cost structure and volatile VIP play.

To fix matters, Melco signed an agreement with A-Max Holdings, an Asian holding company. A-Max is supplying capital to Ama International, which acts as an aggregator for junket operators. In the Macau casino market, VIP customers are brought into casinos by junket operators.

This week, A-Max finally raised $2 billion in Hong Kong currency through a placement on the Hong Kong exchange.

Under the agreement, Melco is guaranteed $30 billion (Hong Kong), or $3.8 billion in U.S. currency, of VIP chip bets each month. Effectively, this doubles the VIP rolling chip volume at Crown Macau. In return, Melco will pay Ama a commission ranging from 1.2% to 1.35%.

Yet this guarantee seems to be little more than a promise. If A-Max can't deliver, then it appears Melco has little recourse.

Doubling the chip volume makes the Crown Macau profitable. But can it really be done?

I remain skeptical. For one thing, Wall Street analysts have been incredibly bullish on the deal. While a partnership could bring substantial profits, I'm still worried the deal could end up being a bust.

According to the A-Max rights offering for its stock deal, the junket aggregators have contracted to bring a minimum of $30 billion (Hong Kong) of chip VIP play to Crown Macau each month. Jefferies analyst Lawrence Klatzkin says A-Max has an 85% chance of moving $45 billion (Hong Kong) to Crown each month.

Melco ends up keeping about 2.5% of that money -- proceeds measured as "hold percentage."

By my projections, the deal should allow Crown Macau to post EBITDA of $175 million next year. Add in about $20 million of EBITDA from the Mocha clubs, and the annual EBITDA comes to $195 million next year. My estimate is a bit higher than the consensus number of $183 million, according to Reuters estimates.

If the junket volume is even higher, EBITDA would be higher. However, margins won't be that impressive -- likely just 12% to 15%, by my estimates. That's far lower than the 27% margin at Wynn Macau, another high-roller casino.

The best-case scenario is that Crown Macau dominates the VIP market. But it's an open debate whether that can happen without sacrificing margins even further.

Furthermore, even if the junket operators are being paid higher commissions to move players to the Crown Macau, it doesn't guarantee the players themselves will want to switch.

At this point, investors can only hope the company executes well -- something management hasn't done so far.

Crown Macau is a small piece in the longer-term Melco story. Analysts project Melco to post $730 million of EBITDA in 2009, when City of Dreams, the firm's next project, opens in Macau. Thus Crown looks to be about 25% of operating cash flow going forward. It does move the valuation needle, but it's not the whole story.

The increased junket VIP play from the A-Max deal starts in the middle of December. If the word on the street ends up being good, Melco could rally in the new year.

The firm does have strong support from several analysts. Jefferies' Klatzkin has a $21 price target. Deutsche Bank analyst Karen Tang has a $22 price target.

At the stock's current level, the upside is tempting. I continue to believe Melco is a good buying opportunity at these levels, but value creation is highly contingent upon this A-Max deal being successful.


In other mock portfolio news, Trump Entertainment ( TRMP) shares reached a new 52-week low this week on news that Dale Black, the company's CFO, has left the firm to work for another casino company, Isle of Capri ( ISLE).

This is now the second key executive to leave Trump this year, after CEO Jim Perry resigned earlier this year.

I continue to recommend that investors avoid buying this name, which I flagged as overvalued back in late January, when the stock was $17.50. At around $4.50 now, I must admit the shares may be nearing a bottom. But investors should first wait for signs that the Atlantic City gambling market is recovering before touching this stock.

Bricks and Mortar Portfolio
A Look at How Nicholas Yulico's Picks Have Performed
Rating Date Price at Rating Rating Current Price* Return**
Brookfield Properties (BPO) 1/23/2007 28.67 Own 20.33 -29.1%
Global Real Estate ETF (RWX) 1/23/2007 64.00 Own 60.91 -4.8%
Ryland (RYL) 1/23/2007 56.00 Flag 24.15 56.9%
Trump (TRMP) 1/23/2007 17.50 Flag 4.68 73.3%
Penn National (PENN) 2/6/2007 45.56 Own 58.51 28.4%
Melco PBL (MPEL) 3/12/2007 15.46 Own 13.27 -14.2%
Home Solutions of America (HSOA) 4/24/2007 4.98 Flag 1.53 69.3%
Starwood Hotels (HOT) 7/12/2007 72.37 Own 52.80 -27%
Standard Pacific (SPF) 10/26/2007 5.25 Flag 3.10 41%
Average Total Portfolio Return, Unweighted, (including closed ratings) 23.1%
Closed Ratings Rating Date Price at Rating Rating Closing Price*** Return**
Hilton (HLT) 3/2/2007 $34.69 Own 47.50 36.9%
Close At Start of Portfolio Current Value*
S&P 500 1427.99 1,485.01 4%
U.S. MSCI REIT Index 1140.36 921.60 -19.2%
*(12/5/07 closing prices)
**For "flagged" stocks, a drop in price is tracked as a positive for the portfolio, and a rise in price is a negative.
***Hilton closed out of portfolio on 10/26/07 because Blackstone Group completed purchase of firm.

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