Macau's casino industry is on a tear. Gross gaming revenue (GGR) surged by 19.1% in 2017, ending three years of successive declines. The overriding questions for 2018 are whether such momentum can last, and if so, will sector balance sheets strengthen enough to drive rating upgrades?

Most rated casino operators with material exposure to Macau beat market expectations for 2017 results (interim and third-quarter). S&P Global Ratings revised the rating outlooks on Melco Resorts (Macau) Ltd. (Melco Resorts, BB/Stable/--) and Studio City Co. Ltd. (BB-/Stable/--) to stable from negative on Nov. 2, 2017, after operating results also exceeded our expectations.

We expect continued GGR growth in Macau, though at a tamer clip. From a rating perspective, we note that casino operators with exposure to Macau have built up larger capital cushions against downgrade triggers in the past year. However, despite stronger buffers and continued revenue momentum, we do not expect many upgrades over the next 12 months. This is because our credit profiles incorporate the high cash flow volatility intrinsic to the industry, and likely increasing distributions to shareholders. Other overhangs include potential large capital outlays if Japan's planned gaming jurisdictions get approved, and uncertainty regarding the expiry of Macau gaming concessions in 2020 and 2022.

We rate four of the six casino concessionaires in Macau (see table 1). These are Las Vegas Sands Corp. (LVS, parent of Sands China Ltd.), Melco Resorts (core operating subsidiary of Melco Resorts & Entertainment Ltd.), MGM Resorts International (MGM, parent of MGM China Holdings Ltd.), and Wynn Resorts Ltd. (Wynn, parent of Wynn Macau Ltd.). We also have ratings on Studio City, which is a sister company of Melco Resorts. Studio City's casino is operated by Melco Resorts under Melco Resorts' gaming concession.

Table 1

Frequently Asked Questions

What's the outlook for Macau's gaming revenue growth in 2018?

Stabilizing economic growth in China, the opening of new casinos, and ongoing infrastructure improvements will continue to fuel growth in Macau's GGR in 2018. We expect mass-market GGR to increase 5%-10% and "VIP" GGR growth to rise by less than 15% in 2018. This should support total Macau GGR growth of 6%-12% this year.

Four new casinos have opened since 2015, adding gaming capacity as well as new nongaming attractions and additional hotel rooms, all of which should help attract more visitors to Macau. Hotel occupancy rates averaged 90% throughout 2017 versus about 85% in 2016, despite the addition of more than 4,700 new hotel rooms (or 15% more rooms) since August 2016. This is driven by the persistent growth in overnight visitors to Macau from Chinese provinces outside of neighboring Guangdong. The opening of MGM Cotai in late January 2018 will add new gaming tables and approximately 1,400 hotel rooms to drive further demand.

Improving infrastructure and transportation connecting Macau to other parts of China should also help drive up visitor numbers and support long-term gaming revenue growth. Both the Hong Kong-Zhuhai-Macau Bridge and the Guangzhou-Zhuhai Intercity Railway Extension are likely to commence operations in 2018, shortening and simplifying travel to Macau from China.

Nevertheless, we anticipate continued high volatility in Macau GGR, given the market's susceptibility to policy changes, economic conditions, and pronounced seasonality.

Chart 1

Table 2

How dependent is Macau on China for visitors and regulatory settings?

Very. Chinese residents make up about 70% of total visitors to this special administrative region (SAR) of China. As such, China's policy on overseas travel and capital controls can have a major impact on visitor flows to Macau, as well as spending patterns.

China's liberalization of capital outflows and overseas travel in the past 15 years have boosted Macau's gaming industry. At the same time, Macau is sensitive to tightening of monetary or administrative policy in China. For example, a vigorous anti-corruption drive in recent years under President Xi Jinping had a dampening impact on consumption of luxury goods and travel. Curbs on capital outflows during periods of stress on the renminbi can also affect the Macau SAR.

Further curbs on capital outflows and money-laundering, a refreshed crackdown on corruption, or a tightening of regulations on junket operators by the Macanese government all constitute risks that could materially weaken Macau gaming revenue growth over the next 12 months.

Is Macau facing policy headwinds, from either China or local administrators, and what does that mean for gaming revenue?

Yes. A tightening regulatory environment is always a key downside risk for Macau's gaming industry, in our view. As an example, in recent weeks, the Chinese government has introduced several new measures to monitor and control cross-border capital flows, adding to measures announced since late 2016 (see table 3). For example, beginning in 2018, China's UnionPay cards are subject to an annual overseas withdrawal limit of Chinese renminbi (RMB) 100,000 (US$15,380) per person, regardless of the number of cards the individual may hold. We do not believe the new measures target the Macau gaming industry. However, these restrictions could negatively affect both the "VIP" (or high-roller) and premium mass segments, by limiting individuals' access to cash or credit in Macau, or reduce their willingness to visit.

The VIP segment is more susceptible to policy changes than the mass market, in our view. Our base case assumes VIP GGR growth to materially decelerate to under 15% in 2018, from 27% growth in 2017. This reflects our expectation of a negative impact from policy headwinds, and a much higher base of VIP revenue from which to grow.

Although the tightening UnionPay controls may affect performance in the mass market's higher end (the premium mass segment), steady and resilient growth in the "grind" mass segment will temper the impact. Overall, we expect mass-market GGR to increase by 5%-10% in 2018, from 10% growth in 2017.

A tightening regulatory environment is always a key downside risk for Macau's gaming industry, in our view.

Table 3

Does Macau favor a VIP-driven gaming market over mass market?

No. We continue to view the mass market as the major driver of sustainable growth in Macau's gaming industry, despite the recent revenue outperformance of the VIP segment. While Macau has traditionally been a VIP-driven gaming destination, most new casinos recently opened or in the pipeline focus more on the mass-market segment and include many nongaming attractions. We believe it is Macau's ambition to evolve into a global tourism and leisure center, such as Las Vegas.

More importantly, the mass market has long been the major contributor to operating profit and cash flow generation for most Macau-based casino operators. This is due to much higher profitability versus the VIP segment. We estimate mass-market EBITDA margins range from 30%-40%. This compares with about 10% for VIP, due to player rebates and high commission rates owed to gaming promoters/junkets. As a result, we can see that in the case of Melco Resorts, the mass market only accounted for 55% of the company's gaming revenue in 2016, but contributed nearly 90% to full year EBITDA.

In addition, we expect continued higher volatility and lower predictability in VIP GGR, because this sector is more sensitive to China's capital controls and anti-money laundering efforts.

Chart 2

Chart 3

Are rating upgrades in the cards, given the strong performance in Macau gaming?

Not at the moment. Our ratings on operators in the market incorporate the Macau gaming sector's history of high cash flow volatility. This approach allows for more stability of ratings, despite the inherently volatile nature of the sector.

In addition, we see overhang risks from potential large capital investments in casino projects in Japan, whose government legalized casinos in 2016 and is planning to release the details for implementation this year (the "Integrated Resorts Implementation Bill"). Although any meaningful capital spending in Japan is unlikely before 2020, commitments to invest in the market may hamper Macau casino operators' ability to build sufficient financial flexibility ahead of the Macau license rebidding process (see next section). Most of our rated casino operators in Macau have already expressed strong interest in pursuing a gaming license in Japan, which may lead to a very competitive bidding process and substantial capital commitment.

Japan's opening could also heighten competition among regional casino markets, which could weigh on Macau gaming's growth prospects and profitability in the longer term.

What's the likely impact of the gaming license expiries in 2020 and 2022?

The gaming license rebidding process in Macau remains unclear to us at this time. However, in our base case, we do not assume any existing concessionaires or sub-concessionaires will lose their licenses. We also do not anticipate the granting of any additional concessions, given the already competitive market conditions and limited land for additional development.

We expect concession renewals to require some form of economic consideration from operators. This could include a potential upfront payment for license renewal, additional capital investment requirements, or a change in the tax regime. A higher tax rate is the least likely outcome, in our view, because Macau's gaming tax rate is already high compared with other gaming markets.

In addition, we think it's likely that the Macau government could extend the 2020 concession expiry to 2022 in order to conduct a synchronized license rebidding process for all operators.

Table 4

How much financial cushion do Macau's casino operators have against rating downgrades over the next 12 months?

We expect the credit metrics of our rated Macau casino operators to improve in 2018, driven by strong industry growth, the ramp-up of new casinos, and moderating capital investments. This should boost the sector's financial flexibility and lower the risk of rating downgrades.

However, the rating outlooks will also depend on casino operators' financial discipline with capital investment and shareholder returns. Macau's six casino concessionaires all paid special dividends or conducted share repurchases in the past two years. Any continuance or enlargement of such shareholder-friendly activities over the next 12 months could materially weaken sector credit metrics and financial cushions.

Table 5

Las Vegas Sands:  LVS's credit metrics provide a substantial cushion relative to our downgrade trigger. However, a rating upgrade is also unlikely given LVS' clear and consistently articulated desire to take on development opportunities, should they arise, that could cause the company to incur additional debt and the absence of a maximum debt leverage tolerance.

Wynn:  Rating downside is limited in 2018 given our forecast for Wynn's leverage to continue improving. That said, we believe the most likely path to a downgrade over the next two years would be financial-policy related, either through a meaningful increase in development spending or increased shareholder distributions.

MGM:  Our rating on MGM is less reliant on the company's performance in Macau, given its much larger exposure to U.S. gaming markets. Rating downside could come from weak operating performance at newly opened resorts or a more aggressive financial policy with respect to acquisitions or share repurchases.

Melco Resorts:  The company's strong operating cash flow should provide a sufficient financial buffer against its potential high dividend payouts and capital investments over the next 12 months. However, rating upside is limited without a robust financial policy framework.

Studio City:  The rating outlook on Studio City is closely associated with the credit profile of Melco Resorts due to our anticipation of extraordinary support from the sister company if needed. We see limited rating downside from a potential deterioration of Studio City's stand-alone credit profile; this could change if the company's capital spending on its phase II project is greater than we estimate, materially weakening the company's liquidity.

RELATED RESEARCH

• Asia-Pacific Sector Outlook 2018: More Positive Despite China Debt And Rate Hike Fears, Nov. 30, 2017
• Industry Top Trends 2018, Nov. 29, 2017
• Why Ratings Upgrades Are Not Currently In The Cards For Macau's Outperforming Gaming Sector, Aug. 7, 2017