With its share price up 3% year to date, Melco Resorts (MLCO -1.28%) has dramatically outperformed the S&P 500 index, which has fallen 20% over the period. That said, the company is far from a safe investment.
Let's explore why regulatory uncertainty in China and weak financials could cause the casino operator to underperform over the long term.
What is Melco Resorts?
Founded in 2004, Melco Resorts is a Hong Kong–based casino and resort operator. It focuses on the Asian market, with its largest properties in Manila, the Philippines, and Macao, China -- a city that was the gaming capital of the world before the COVID-19 pandemic. Like all tourism hotspots, Macao faced a catastrophic dip in arrivals during the crisis. But unlike other destinations, such as Las Vegas, it has been very slow to recover. Melco's third-quarter results highlight the severity of the problem.
Image source: Getty Images.
Total revenue fell 46% year over year to $241.8 million -- a dip management credits to the travel restrictions from mainland China and the Chinese government's temporary closure of Macao resorts in July.
According to Bloomberg, Macao's tourism levels remain dramatically below pre-pandemic levels, with just 580,000 tourist arrivals in October 2022 compared to 2.9 million arrivals at the same time in 2019. By now, Macao has been under various restrictions for almost three years, raising serious questions about its viability as an investment destination. That said, there may be light at the end of the tunnel.
Is 'zero COVID' ending?
Following widespread protests, mainland China is finally moving to end its strict zero-COVID-19 policy, which was intended to totally prevent infections in the country. Policymakers have announced their intent to shift from a strategy of containing the virus to living with it via a combination of vaccines and other medical treatments. This move is obviously good news for China-based companies like Melco, but there are also reasons why investors may want to temper their enthusiasm.
Because China has been under lockdowns and restrictions for so long, it hasn't built up the same level of herd immunity as other countries. And this could lead to significant social and economic disruption, which has already started in China's capital, Beijing, according to Reuters.
Macao depends on mainland China for 89% of its visitor traffic, so spillover effects are likely. The region's secretary for social affairs and culture, Elsie Ao, believes that up to 80% of the city's population could get the virus following the end of zero COVID. For its part, the jurisdiction has eased restrictions by allowing home isolation (instead of isolation at an approved facility) for guests arriving from the mainland.
Is Melco stock a buy?
While Melco's immediate future is undeniably challenging, its long-term prospects are also grim. After three years of heavy restrictions in its core market, finances have deteriorated. As of the third quarter, the company reports long-term debt of $7.73 billion compared to cash of just $1.52 billion. The leverage will be a burden on cash flow because it has to be paid back, and it will generate interest expense -- a sum that totaled a whopping $94 million in the period.
With a price-to-sales (P/S) multiple of 3.8, Melco Resorts stock is valued significantly higher than the S&P 500 average of 2.3. This valuation looks too high considering the company's dropping revenue, weak balance sheet, and continued uncertainty in the Chinese market.
