Initiation Asia Entertainment & Resources Ltd. (AERL Nasdaq $6.02) Macau Gaming Revenue is a Function of China s High Liquidity

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1 EQUITY RESEARCH INITIATION REPORT China March 23, 2012 Closing Price (3/22/12): $ Month Target Price: $ Week Range: $ $10.87 Market Cap (MM): $235 Shares O/S (MM): 39.0 Float (MM): 22.5 Avg. Vol. (000) Book Value/Share: $8.40 Dividend/Yield: $0.1/2% Risk Profile: High GAAP FYE: December EPS P/E 2011A $ x 2012E $ x 2013E $ x LT Earnings Growth 10%-15% INSERT PRICE CHART Source: bigcharts.com Echo He, MD, PhD (212) ehe@maximgrp.com Initiation Buy Asia Entertainment & Resources Ltd. (AERL Nasdaq $6.02) Macau Gaming Revenue is a Function of China s High Liquidity We are initiating coverage of Asia Entertainment & Resources Ltd. (AERL) with a Buy rating and a 12-month price target of $12. AERL is a VIP gaming promoter in Macau with about 2%-2.5% share of Macau s VIP gaming market, which dominates Macau s gaming industry and has been a major growth driver since In our view, continued wealth accumulation and liquidity in Mainland China should provide sustainable benefits to Macau s gaming industry as well as AERL s operations; AERL s strategy to constantly expand VIP room capacity, agent networks, and cage capital should support the company s growth at an above-industry average rate. In addition, AERL s 15% cash dividends and discounted valuation should provide reasonable downside protection. We believe China s increasing wealth, widening income gap, and relaxed monetary policies will likely continue to drive Macau s gaming industry growth in the foreseeable future. China s decade-long high economic growth has created a large demand pool for Macau s casinos. Members of the booming urban population with increasing disposable incomes serve the mass floor, while high-net-worth individuals become VIP patrons. In addition, Mainland China s capital overflow has provided the critical capital supply to Macau, which depends on increasing gaming capital to fuel revenue growth. We believe VIP gaming will likely remain dominant and continue to drive Macau s gaming industry growth. VIP gaming revenue accounted for 73% of Macau s total gaming revenue in 2011, with a CAGR of 38% since 2005 (beating the 27% CAGR of mass-floor revenue). Controlling more than 90% of VIP gaming revenue in Macau by supplying players and the majority of gaming capital, Macau s VIP gaming promoters are both drivers and beneficiaries of the strong gaming revenue growth. Above-industry average growth trading at a deep discount to peers. AERL s growth is mainly driven by expanding capacity (adding more VIP rooms/tables) and cage capital (higher dollar turnover generates higher commission revenue). AERL is trading at 2.8x 2012 P/E and 4.2x 2012 EV/EBITDA (not counting markers receivables as cash), more than 70% and 50% discounts to casino operator averages, respectively. Our price target of $12 is based on 7x our 2012 EBITDA estimate, a 32% discount to the casino operators average, given its limited scale of operation. Maxim Group LLC, 405 Lexington Avenue, New York, NY SEE PAGES FOR IMPORTANT DISCLOSURES AND DISCLAIMERS

2 CORPORATE PROFILE Asia Entertainment & Resources Ltd. Unit 605, East Town Building, 16 Fenwick Street, Wanchai, Hong Kong Senior Management: Lam Man Pou, Chairman and CMO Vong Hon Kun, COO Leong Siak Hung, CEO Li Chun Ming, CFO Company Description: Asia Entertainment & Resources Ltd. (AERL) is a mid-tier Macau VIP gaming promoter that runs three VIP rooms and 29 VIP gaming tables. Its revenue is mainly a fixed-rate commission 1.25% of the rolling chip turnover generated from its VIP gaming operation, which accounts for 2%-2.5% of Macau s VIP gaming market. Investment Risks: Potential government restrictions. If the Chinese government implements policies to cool down the gambling economy, it could jeopardize Macau s gaming industry. Economic downturns. A major economic downturn, such as the 2008 global financial crisis, could significantly undermine capital liquidity in China, resulting in less interest in gambling from VIP players and limited credits to junket systems. Rising regional competition. Singapore and South Korea have built gambling businesses; Taiwan s government also has plans to develop its gaming industry. However, these local competitors lack scale, international casino operators, and the convenience of access. Uncontrollable events. Pandemics or natural disasters could impact Macau s gaming revenue. Share/earnings dilution. In order to achieve growth, AERL has to constantly seek more cage capital. Either debt or equity raises could dilute earnings attributable to current shareholders. Institutional Ownership: 10.7% Insider Ownership: 47.4% Shares Short (MM): 0.6 Balance Sheet Summary: $M (As of December 31, 2011) Equity: $158.8 Assets: $328.4 Long-Term Debt: $92.5 ROE 2012E: 42% Quarterly EPS (GAAP) 2011A 2012E 2013E 1Q $0.37 $0.47 2Q $0.54 $0.51 3Q $0.68 $0.58 4Q $0.41 $0.55 FY $2.00 $2.11 $2.55 Quarterly Net Revenue ($M) 2011A 2012E 2013E 1Q $51.3 $70.3 2Q $55.2 $74.5 3Q $74.4 $85.9 4Q $69.7 $88.2 FY $250.6 $318.9 $386.6 Fiscal Year Ends December Analysts Following the Co.: 3 (Other than Maxim Group LLC) Consensus Estimates: GAAP EPS Current Year: $2.12 Next Year: $2.67 Auditor: UHY LLP 19 West 44th Street, New York, NY Investor Relations Contact: ICR william.schmitt@icrinc.com Maxim Group LLC 2

3 TABLE OF CONTENTS CORPORATE PROFILE INVESTMENT THEMES AND DISCUSSIONS China s flooding wealth supports Macau s gaming prosperity VIP revenue dominates Macau gaming China s high liquidity has fueled VIP gaming The essential role of VIP gaming promoters Growing supply also drives Macau s gaming revenue AERL s growth depending on capital and VIP room capacity VALUATION INVESTMENT RISKS 14 Potential government restrictions Economic downturns Rising regional competition Uncontrollable events Share/earnings dilution INDUSTRY AND COMPANY BACKGROUND The development of Macau s gaming industry Company history Management profile FINANCIAL MODELS..18 Income statement Balance sheet Cash flow statement DISCLOSURES and DISCLAIMERS...21 Maxim Group LLC 3

4 INVESTMENT THEMES AND DISCUSSIONS We are initiating coverage of Asia Entertainment & Resources Ltd. (AERL) with a Buy rating and 12-month price target of $12. Macau s total gaming revenue grew at a 34% CAGR from 2005 to 2011, reaching $34B that s more than five times the revenue of Las Vegas. VIP gaming contributed to 73% of Macau s total gaming revenue in 2011 and has been a major driver for market growth, with a 38% CAGR since 2005 (vs. mass floor gaming s 27%). VIP gaming promoters control roughly 90% of Macau s VIP gaming market and are crucial in recruiting VIP players and providing VIP gaming capital. AERL operates a VIP gaming promotion business that contributes 2%-2.5% of Macau s VIP gaming revenue. Its growth mostly rides on the prosperity of Macau s gaming market (VIP gaming in particular), which will likely continue to benefit from Mainland China s growing wealth and capital liquidity. Given AERL s public capital market access and management s drive to excel in execution, the company will likely be able to continue its strategy to expand VIP room capacity and cage capital simultaneously. As a result, AERL will likely achieve abovethe-market average growth in the coming years. China s Flooding Wealth Supports Macau s Gaming Prosperity A widening income gap as a fall-out of China s economic growth has driven the upper class to grow faster than the middle class. China s wealth accumulation accelerated after 2000, as a result of a rapid increase of manufacturing and export activities driven by strong global demand. Meanwhile, the unbalanced profit sharing between business owners and the general labor force propelled the wealthy class to grow faster than the rest. The large amount of hot money controlled by this small group of people has generated the country s high liquidity in the capital market, fed the over-investment in short-turnaround sectors, and caused large amounts of disposable cash to drive domestic and overseas consumption and flood the asset investment markets. In 2011, the number of high net worth (with net asset greater than $1M) individuals in Mainland China (excluding Hong Kong and Taiwan) were ranked among the top 10 countries/regions in the world, with the number of ultra-high net worth (with net asset greater than $1B) individuals ranked only next to the U.S. (Exhibit 1). Exhibit 1. China s High Net Worth Individuals in Comparison to the United States and Other Asian Regions Country/ Number of High Net Worth Individuals with Wealth Range of Region $1M-$5M $5M-$10M $10-$50M $50-$100M $100-$500M $500M-$1B >$1B US 8,759, , ,173 23,554 10, Japan 2,933, ,319 52,924 2, Germany 1,608,559 95,738 45,698 2,720 1, Mainland 899,203 71,320 41,234 3,270 1, Taiwan 308,170 22,247 12, Korea 194,936 14,107 7, India 174,452 16,623 10,919 1, Singapore 169,489 9,435 4, Hong Kong 75,713 7,832 5, , , , , , ,000 Source: BCG China Wealth Report 2011, Credit Suisse Global Wealth Databook 2011 and Maxim Group estimates - No. of High Net Worth Household in China >$15M $7.5M-$15M $1.5M-$7.5M $1M-$1.5M Maxim Group LLC 4

5 Exhibit 2. Mainland China is the Major Source of Macau s Visitors and VIP Gaming 2011 Macau Visitors by Region Rest of Other Asia 3% 8% Taiwan 4% Hong Kong 27% China 58% 2011 VIP Revenue by Region Taiwan, 5% Hong Kong, 8% Other, 5% China, 82% Fujian, 10% Sichuan, 10% 2011 China VIP Revenue by Region Beijing, 10% Other, 10% Zhejiang, 10% Guangd ong, 50% Source: Macau Gaming Inspection and Coordination Bureau, Statistics and Census Service Macao and Maxim Group estimates The wealth accumulated in China has been a main driver of the gaming industry growth in Macau. Macau sits in the center of perhaps the world s largest gaming population. It has a monopoly on China s gaming industry gambling is banned in the rest of China. Therefore, it is the main gambling outlet of the million or so wealthy Chinese citizens, who view Macau s VIP gaming as highly entertaining and a symbolization of their fast financial success. Since the relaxation of VISA approvals in Mainland China in 2003, visitors from Mainland to Macau quickly surpassed all the rest of Asia (including Hong Kong) combined. In 2011, 58% of Macau visitors and 82% of VIP gaming revenues came from the Mainland (Exhibits 2). As a result, Macau s gaming industry has achieved tremendous growth. Total gross gaming revenue (GGR) achieved a 32% CAGR from , without a single declining year. The city s GGR surpassed that of the Las Vegas Strip in 2006 and more than quadrupled in the five years afterwards (Exhibit 3). Meanwhile, EBITDA margins and ROA of large casino resorts stood at 11%-16% and 20%-60%, respectively, during the same period, higher than their counterparts in Las Vegas on average. In 2008, when the world financial crisis and Chinese government restrictions on traveling to Macau double-hit the gaming industry, Macau s visitors from Mainland declined 22%, and its GGR growth slowed down to 10% y/y. Exhibit 3. Historical High Growth and Profitability of Macau s GGR vs. Growth of Las Vegas $B Gross Gaming Revenue: Macau vs. Las Vegas Strip Las Vegas Strip Revenue ($B) Macau Revenue ($B) $B EBITDA vs. Revenue of Macau Casinos Casino EBITDA ($B) Casino Revenue ($B) EBITDA margin % E 35% 30% 25% 20% 15% 10% 5% 0% Source: Macau Gaming Inspection and Coordination Bureau and Maxim Group estimates Maxim Group LLC 5

6 Exhibit 4. Gaming Revenue: VIP Gaming vs. Mass Gaming Gaming Revenue ($B) VIP Mass Gross Gaming Revenue: VIP vs. Mass Source: Macau Gaming Inspection and Coordination Bureau, company reports and Maxim Group estimates VIP Revenue Dominates Macau Gaming VIP Mass Gaming Gaming Total 2011 Gaming Revenue Breakdown: % Total Gaming Revenue 73% 27% 100% % Total Visitors 98% 2%-3% 100% CAGR of Gaming Revenue: % 43% 28% % 27% 34% Win Rate 2.85%-3.0% 25%-35% 8.8%-11.6% (% of Rolling Chip Turnover) In contrast to the United States, VIP players dominate Macau s gaming revenue, contributing 73% of total gaming revenue in 2011 (despite only accounting for 2%-3% of total Macau visitors). VIP gaming revenue out-grew mass gaming revenue with 38% CAGR vs. 27% during (Exhibit 4). Mainland China supplies the majority of VIP players, contributing 82% of total VIP gaming revenue in Guangdong province, due to its proximity to Macau, accounted for roughly 50% of total Mainland VIP gaming revenue, followed by Beijing, Zhejiang, Sichuan, and Fujian (all relatively developed, affluent areas, Exhibit 2). However, according to AERL s management, VIP players come from everywhere in the country; relatively remote areas, such as Inner Mongolia, Shanxi, and Northeast provinces, also source VIP players, due to increasing local wealth from business activities, such as real estate development and natural resource exploration, among others. China s High Liquidity Has Fueled VIP Gaming On the other hand, the accumulated wealth in China has also driven the growth of gaming capital, which is used as credit extended to VIP players. Over the years, gaming revenue per VIP player has increased simultaneously with the total number of VIP players. The growth of Macau s GGR is correlated to China s relaxed monetary policy and high inflation, suggesting there may have been capital overflow from Mainland to Macau as a form of alternative investment (Exhibit 5). Comparing to developed countries, investment alternatives lagged behind the increasing individual wealth in China; there are limited off-shore investment opportunities due to the government s tight control on cross-border currencies. As a result, underground financing/investment activities are often able to attract large amounts of capital, as well as achieve scale and sophistication. Short-term loans to businesses, including gaming operations, may be among these alternatives. Per our checks, short-term loans to junket systems could make 2% monthly interest (a 24% annual rate), or even higher for smaller/less credible borrowers. The rates of return are considerably higher than those of real estate and/or the stock market; both have been volatile and disappointing recently. Maxim Group LLC 6

7 Exhibit 5. Growth of Macau s Gaming Revenue vs. China s Loans, Money Supply, and Inflation Macau GGR Y/Y Growth Macau GGR Y/Y Growth 100% 80% 60% 40% 20% 0% -20% 100% 80% 60% 40% 20% 0% -20% Macau GGR Growth vs. China's Total Loan and M2 Money Supply Growth GGR (left) Total Loans (right) M2 Money Supply (right) 1Q06 2Q06 3Q06 4Q06 1Q07 2Q07 3Q07 GGR (left) China CPI (right) 4Q07 1Q08 2Q08 1Q06 2Q06 3Q06 4Q06 1Q07 2Q07 3Q07 4Q07 1Q08 2Q08 Macau GGR Growth vs. China CPI 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 Source: Macau Gaming Inspection and Coordination Bureau, China National Bureau of Statistics and Maxim Group estimates The Essential Role of VIP Gaming Promoters VIP gaming promoters (junket operators), through their collaborating agents (junkets), supply 90% of all VIP players, who contribute more than 70% of Macau s gaming revenue. We estimate VIP gaming promoters (sometimes including agents) provide the majority of gaming credits to VIP players (casinos make up the balance). Thus, casino operators are able to increase their working capital leverage more revenue may be generated from the players. The effective use of VIP gaming promoters may often determine the growth prospective of casino operators. Starting from mid 2010, Sand China (1928-HK, NR) focused on building its direct VIP gaming operation, a strategy that drove away VIP gaming promoters and their controlled agents. As a result, Sands China gradually lost its share in Macau s VIP gaming revenue from 22% in June 2010 to 13% in August The economic incentives to the VIP junket system are substantial. After tax, the majority of the casino wins goes to the junket system. Macau s gaming tax runs at 39% of casino revenue. Commission to VIP promoters cost casino operators ~44% of their gaming revenue, leaving them 16% margin (Exhibit 9). To VIP promoters, the majority (~75%) of their commission revenue goes to their agents, who may use part of their portion of revenue to rebate VIP players in order to win repeated visits. This high-reward mechanism has effectively driven all parties involved to work hard on generating higher and higher gaming revenues. 40% 35% 30% 25% 20% 15% 10% 10% 8% 6% 4% 2% 0% -2% Total Loan and M2 Y/Y China CPI Maxim Group LLC 7

8 The growing sophistication of the junket system is an important driver to Macau s gaming industry; meanwhile, the VIP gaming promoters benefit from the industry s continued growth. Macau s junket system started in the early 1960s in an effort by casino operators to recruit players, extend credit to players, and reduce bad debt. Over the years, some large gaming promoters have become sophisticated corporations, providing services to various gambling activities, including casinos, online gaming, and sports betting. Many of them also have diversified capital resources, including casinos lines of credit, the equity market, and private loans. Their associated agents have channel access to VIP players in the Mainland. The agents relationships enable them to direct players to affiliated casinos, usually multiple ones, and collect debts relatively easily after all, personal relationships are an important reason of doing business in China. In addition to access to VIP players in Mainland China, some agents provide a portion of gaming capital to VIP players, extending VIP gaming promoters leverage. In this case, promoters would give a higher cut of commissions to their agents. VIP gaming promoters are increasingly important when casino operators are increasingly relying on Mainland VIP players, who make up the overwhelming majority (82% in 2011) of the total VIP gaming market (Exhibit 2). It is extremely difficult to obtain the credit history of Mainland VIP players; it is similarly difficult for VIP players to bring large amount of currency to Macau due to China s strict control on cross-border currency flow (despite tangible efforts of relaxation, the Chinese government still imposes a $5,000 limit on the amount of cash every citizen can bring on a single trip outside Mainland without a permission). VIP players from Mainland come to Macau with only limited cash. It is the gaming promoters who lend them large amount of credit, in the form of gambling chips, to play and, if the players lose, collect debts afterwards. Large amount of cash could be brought across the border through underground banking systems to repay the debt, given sufficient time. Growing Supply also Drives Macau s Gaming Revenue New gaming facilities and infrastructure improvement have been key drivers of gaming demand in Macau. During the past decade, new facility openings have been closely associated with accelerated gaming revenue growth (Exhibit 6). In May 2011, the new Galaxy Macau Resorts opened. Going forward, all six casino operators have plans to add more tables and slot machines. Sands China has scheduled to open a new casino/resort combination in 2012 (at Cotai Central). Melco-Crown and Wynn may also build new facilities in Cotai, which could open from 2014 to In addition, the government has plans to further ease communication to Macau. Current plans include the Hong Kong-Macau- Zhuhai (Mainland) bridge, an expansion of the Macau airport, two new tunnels, a second ferry terminal, a light rail transit system, and expansion of Macau-Zhuhai border crossing. New gaming facilities and infrastructure improvement should facilitate growth of both mass and VIP gaming; however, we believe mass gaming may benefit even more. Maxim Group LLC 8

9 Exhibit 6. Historical New Casino Opens vs. GGR Growth Gaming Revenue ($B) VIP Mass Sands Macau Gross Gam ing Revenue: VIP vs. Mass SJM Grand Lisboa MPEL Altira Macau Sands Venetian MGM Grand Macau Wynn Macau Sands Plaza/ Four Seasons Wynn Encore Oceanus Galaxy Macau MPEL City of Dreams Sands China at Cotai Source: Company reports and Maxim Group estimates AERL s Growth Depends on Capital and VIP Room Capacity AERL is a mid-tier VIP gaming promoter with 2%-2.5% of Macau s VIP gaming market. Although highly developed, the VIP gaming market is still fragmented. There are about licensed VIP gaming promoters in Macau, serving about 300 VIP gaming rooms. However, the VIP gaming market is skewed to larger players. The top five players account for more than 50% of total VIP gaming revenue. The mid-tier promoters, including AERL, consist of companies, aggregately contributing ~20%-30% of total VIP gaming revenue; and the rest make up the balance. AERL operates three VIP rooms one in the Venetian Macau, one in Galaxy Macau, and one in the Galaxy StarWorld Casino, with 5, 12 and 12 game tables, respectively, on a basis of a network of more than 1,600 agents and collaborators across Asia. AERL has annually renewable agreements with casino operators for each VIP room. We believe the risk of losing agreements is low at the current stage, given the company s historical performance. Exhibit 7. Summary of AERL s Operations VIP Room Galaxy StarWorld Galaxy Macau Venetian Macau Operating Subsidiary Sang Heng Gaming San Lung Gaming King's Gaming Promotion Company Promotion Company Promotion Ltd. Total No. of Tables Week-day entry: HK$0.3M ($0.04M)/player; Weekend entry: HK$0.5M ($0.06M)/player Tables in Private Room Week-day entry: HK$3M ($0.4M)/player; Weekend entry: HK$5M ($0.6M)/player Source: Company reports and Maxim Group estimates Maxim Group LLC 9

10 Two integral factors are the keys to the growth of AERL as well as competing VIP gaming promoters alike, cage capital and the number of contracted VIP room. Cage capital is the limiting factor to VIP gaming revenue per room. The cage is the transaction place the casino sets up in each VIP room, i.e. each VIP room is run on an enclosed financing system. The cage capital is the total working capital that s available to VIP players bets in each room. More cage capital enables the VIP room to achieve higher utilization by generating higher rolling chip turnover (RCT). In Macau, the average monthly RCT ranges from 6-9x the cage capital. Increasing velocity of cage capital turnover should help increase RCT to a certain extent; however, cage capital ultimately limits the growth of RCT. As of December 31, 2011, AERL had cage capital of $256M, including $46.3M interest-free credit lines directly from casino operators and a convertible term loan of $62.6M (zero-coupon, expiration in May 2014, conversion price of $20/share, and callable at above $25/share) from its Chairman and COO, AERL s founders and shareholders. Private market financing has become an important source of cage capital in recent years. VIP gaming promoters have been seeking shortterm loans from private investors who are attracted by the lucrative returns. Interests could run at 2% per month (24% annually) or even higher, depending on the reputation of promoters credits/reputation. We estimate a significant portion, if not the majority, of such financing comes from Mainland China, where bank deposit interest lags behind inflation and returns from property and security markets have been volatile in recent years. On the other hand, AERL could also drive growth by acquiring VIP rooms and collaborating agents. In November 2010, the company acquired King s Gaming, which operated the Wenzhou VIP Room at the Venetian Hotel and Casino in Macau, for $36M cash and 1.5M shares of AERL s common stock. The acquisition added five tables in the Venetian as well as associated agents and their networks. Exhibit 8. AERL s Revenue Growth Correlates the Market and Is Limited by Cage Capital AERL Revenue ($M) AERL Rev vs. Total and VIP Gaming Revenue AERL Revenue (left) M acau Total Gaming (right) VIP Gaming (right) 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 Source: Macau Gaming Inspection and Coordination Bureau, company reports and Maxim Group estimates Total and VIP GGR ($B) $'s in millions Casino credit $ 46.3 Shareholder loans (from AERL's Chairman and COO) $ 62.6 AERL Equities $ Total cage capital $ VIP room monthly chip turnover 6 x 9 x Est'd monthly rolling chip turnover $ 1,541 $ 2,312 Est'd annual rolling chip turnover $ 18,493 $ 27,740 AERL commission 1.25% Est'd AERL annual revenue $ $ Est'd Revenue/Cage Capital 0.9x 1.3x Maxim Group LLC 10

11 AERL s revenue is based on a fixed commission 1.25% of its dollar amount of RCT. There are basically two forms of revenue models available to VIP gaming promoters like AERL: fixed commission on RCT and win split. Casinos use non-negotiable chips in VIP rooms to calculate transaction volume and/or the bets VIP players make. Such chips are specific to each VIP room and are not inter-exchangeable among VIP rooms. Exhibit 9 illustrates the circulation of non-negotiable chips and cash chips, as well as VIP room operations. Commissions are calculated and paid out by the casinos to VIP gaming promoters on a monthly basis, while the pay cycle of commissions from VIP promoters to agents varies from 15 days to 60 days (30 days on average). Macau s six casino operators, three concessionaires and three sub-concessionaires (Exhibit 12), capped commission to VIP gaming promoters at 1.25% of the dollar value of RCT. Operating on fixed commission may spare VIP gaming promoters from the revenue volatility directly associated with casinos net wins. However, higher win rates require slower RCT and thus indirectly reduce the commissions to VIP gaming promoters. Alternatively, VIP gaming promoters may choose to earn a percentage of the casino s net win. Although casinos do not have an upper limit for the percentage of revenue that goes to VIP gaming promoters, the win split is usually 45%-50% of the casino s net win. On this revenue model, however, VIP gaming promoters bear the risk of sharing net losses with the casino operators. Exhibit 9. Illustration of VIP Room Operations and Economics of VIP Gaming Participants Buy chips, maintains betting volume and collect debt Casino Operators Extend credits (in chips) and pay commission Assumed win rate 2.85% as % of rolling chip turnover (RCT) % of RCT % of GGR Collect debt VIP Promoters Agents Players Extend credits (in chips), collect markers and pay commission Place bet so that chips are recycled Extend credits (in chips) and collect markers Gaming revenue 2.85% 100% Less: Gaming taxes 1.14% 40.0% Commission to VIP promoters 1.25% 43.9% Casino margin 0.46% 16.1% Revenue of VIP gaming promoters 1.25% 43.9% Less: Commission to agents 0.95% 33.3% Rolling Tax 0.01% 0.4% VIP Room Administration 0.03% 1.1% SG&A 0.06% 2.1% VIP gaming promoter margin 0.20% 7.0% Total economics to junket system 1.25% 43.9% Note: AERL s operating margin was a blended average of direct sourcing VIP players and sourcing VIP players through agents, thereby higher than calculated 20% above. Source: Company reports and Maxim Group estimates Maxim Group LLC 11

12 VALUATION A discount from the major casino operators in Macau is appropriate for AERL. We expect AERL to achieve 27% and 21% revenue growth in 2012 and 2013, respectively, driven by increasing cage capital and possibly additional VIP rooms under management. Assuming SG&A expenses increase slightly faster than revenue in 2012, but at a similar rate as revenue growth in 2013, we estimate $2.11 and $2.55 EPS in the two years, respectively, suggesting 2.8x 2012 and 2.4x 2013 P/E multiples, vs. the 10.3x and 9.2x average EV/EBITDA multiples of Asia s casino and hotel companies. We believe that AERL s P/E multiple is comparable to casino operators EV/EBITDA multiple, as the company does not need capital expenditures. We also modeled 15% share dilution because the company will likely raise capital near term to fuel its growth. Long term, we expect AERL to fulfill its capital needs with retained earnings and casino credits. We value AERL at 7x our 2012 EV/EBITDA estimate, leading to a 12-month price target of $12. The price target implies more than 30% discount to average EV/EBITDA multiple of Asian casino operators. Exhibit 10. Comparable Company Analysis 3/22 MktCap EPS P/E EBITDA EV/EBITDA Company TKR Price (mm) 12E 13E 12E 13E 12E 13E 12E 13E Asia Entertainment & ResoAERL $ 6.02 $ 233 $2.11 $ x 2.4x $ 88.1 $ x 3.6x Asia Casino & Hotel Companies Sands China 1928-HK $ 3.92 $ 31,574 $ 0.19 $ x 14.9x $ 2,121.3 $ 2, x 11.4x Wynn Macau 1128-HK $ 2.94 $ 15,228 $ 0.18 $ x 13.9x $ 1,129.5 $ 1, x 11.5x SJM 880-HK $ 2.12 $ 11,729 $ 0.15 $ x 12.6x $ $ 1, x 8.7x Galaxy Entertainment 27-HK $ 2.63 $ 10,965 $ 0.18 $ x 11.8x $ 1,045.5 $ 1, x 9.6x Melco Crown 6883-HK $ 4.77 $ 7,892 $ 0.22 $ x 19.0x $ $ x 7.6x Crown Ltd CWN-AU $ 9.24 $ 6,730 $ 0.60 $ x 13.5x $ $ x 11.0x MGM China 2282-HK $ 1.79 $ 4,997 $ 0.14 $ x 11.2x $ $ x 6.9x Genting HK 678-HK $ 0.38 $ 2,918 $ 0.02 $ x 13.9x $ $ x 24.5x Tabcorp TAH-AU $ 2.86 $ 2,040 $ 0.51 $ x 11.6x $ $ x 4.5x Naga Corp 3918-HK $ 0.46 $ 956 $ 0.05 $ x 8.0x $ $ x 5.4x Average 15.6x 13.0x 10.3x 9.2x US Casino & Hotel Companies Las Vegas Sands LVS $ $ 42,267 $ 2.58 $ x 18.7x $ 4,043.0 $ 4, x 8.1x MGM Resorts MGM $ $ 39,339 $ (0.46) $ (0.16) $ 1,929.4 $ 2, x 23.5x Wynn Resorts WYNN $ $ 12,749 $ 5.85 $ x 18.8x $ 1,620.4 $ 1, x 7.8x Melco Crown MPEL $ $ 7,637 $ 0.63 $ x 17.5x $ $ x 9.5x Boyd Gaming BYD $ 7.75 $ 671 $ 0.27 $ x 20.2x $ $ x 6.4x Pinnacle Entertainment PNK $ $ 649 $ 0.71 $ x 13.4x $ $ x 5.9x Ameristar Casino ASCA $ $ 641 $ 2.19 $ x 8.3x $ $ x 6.9x Monarch Casino & Resort MCRI $ 9.82 $ 158 $ 0.77 $ x 10.7x $ 35.8 $ x 3.8x Century Casinos CNTY $ 3.01 $ 72 $ x -- $ x -- Average 18.5x 15.4x 5.3x Source: Company reports and Maxim Group estimates. 5.3x Maxim Group LLC 12

13 Our 10-year discounted cash flow (DCF) analysis supports our multiple-based valuation. We model steady revenue growth after 2013, 10% y/y within our projected horizon and proportionally increase of working capital. Using a 2% risk-free rate, 8% market premium, and 1.2x beta (given that gaming is a subject of economic health), we derived WACC at 12%. At a 12% annual discount, AERL s shares have a present value of $11.74-$13.62 per share, suggesting that our DCF analysis supports our comparable company analysis-based price target. Exhibit Year DCF Analysis Long Term Growth Rate 3% 4% 5% 6% 7% Disc. Rate Present Value of Equity per Share 10.0% % % % % % % Source: Company reports and Maxim Group estimates. Maxim Group LLC 13

14 INVESTMENT RISKS Potential Government Restrictions We believe government regulation is the top risk to Macau s gaming industry. Historically, Mainland Chinese businessmen and government officials have been found involved in scandals such as money laundering, problem gambling, and corruption in Macau s casinos. At times, the Chinese government may have been afraid that an over-expansion of the gambling industry may adversely affect China s social stability, thereby implementing policies to cool down the gambling economy. Such policies include but are not limited to visa restrictions for Mainland citizens to travel to Macau and tighter control of currency when crossing the border. Economic Downturns A major economic downturn, such as the 2008 global financial crisis, could significantly undermine capital liquidity in China, resulting in less interest in gambling from VIP players and limited credits to junket systems. We believe this was the main culprit behind the slow growth of Macau gaming revenue in That said, internal corrections of the Chinese economy may or may not impact the wealth of high-net-worth individuals. Rising Regional Competition Singapore has built a cluster of casinos in recent years. South Korea has a small-scale gambling business on Jizhou Island, which is close to China s east coast, Shandong peninsula. Taiwan s government is also discussing plans to develop its gaming industry on one of its smaller islands. All local competitors, however, relatively lack scale, international casino operators (which guarantees professionally run gaming operations), and/or convenience of access. That said, Macau does have a higher tax rate (39%) on the gambling industry than South Korea (30%) and Singapore (15%). Uncontrollable Events Any uncontrollable events such as pandemics and natural disasters could have grave impact on Macau s gaming revenue. In 2003, China (including Hong Kong) experienced a major breakout of SARS (severe acute respiratory syndrome), and traveling was greatly prohibited. Macau s gaming revenue growth significantly slowed during the time. Share/Earnings Dilution As discussed above, the company s revenue is a fixed percentage of its rolling chip turnover, which is subject to cage capital. In order to achieve growth, AERL has to constantly seek more cage capital, in the form of either debt or equity. This may dilute earnings attributable to current shareholders, unless the company obtains interest-free credits. Maxim Group LLC 14

15 INDUSTRY AND COMPANY BACKGROUND The Development of Macau s Gaming Industry Gaming has a long history in Macau. After the mid 19 th century, the Portuguese colonial government gained full sovereignty over Macau and started to regulate its gaming activities. In the first half of the 20 th century, gaming was largely tolerated by the Portuguese as a way to support Macau s economy in competition against larger and better positioned Hong Kong, which was at the time controlled by Great Britain. The first gambling concession, an exclusive license, was granted in 1934 to Tai Xing Company, which became a monopoly, with some help from secret societies, for more than 20 years. In 1962, the monopoly switched to Stanley Ho s STDM (Sociedade de Turismo e Diversões de Macau) in an effort by Portuguese rulers to sooth political conflicts with Mainland China. Ho s proposal of building Western style new casinos to attract tourists and generate quick profits and using gambling profit to modernize Macau s infrastructure was financially attractive to the Portuguese government. In exchange, STDM became Macau s new gaming monopoly and was able to develop without interference from the colonial government. STDM was able to renew its exclusive gaming license every five years multiple times until the turn of the new century. After the handover of Macau from Portugal to China, Macau s new government executed a plan to liberalize its gaming industry in order to bring in more foreign investment and economic opportunities to the region. In 2002, when STDM s license was up for renewal, Macau s government awarded three gaming licenses, instead of one, to SJM (Sociedade de Jogos de Macau, reorganized from STDM), Galaxy Resort and Casino Company, and Wynn Resorts. The three concessionaires subsequently sublicensed their rights to MGM-Mirage, Las Vegas Sands and Melco-Crown, respectively, also under Macau government s programs. To date, despite continued expansion of SJM, its slice of the Macau gaming industry was significantly reduced (Exhibit 13). Exhibit 12. Summary of Macau s Casino Operators (Concessionaires and Sub-concessionaires) Sub- Licensed Controlling Casinos Concessionaire Concessionaire From Shareholder in Operation SJM (880-HK, NR) Stanley Ho and Family SJM has ownership in 20 of Macau's 33 casinos, including 100% ownership in Grand Lisboa, Casino Lisboa and Casino Oceanus at Jai Alai. It also has the monopoly in Macau's sports betting, the Macau Jockey Club and the Macau Canidrome (greyhound racing). Galaxy (27-HK, NR) Lui Family City Club Casinos, StarWorld Casino and Galaxy Macau Casino Wynn Resorts (1128-HK, NR) MGM China (2282-HK, NR) Sands China (1928-HK, NR) Melco-Crown (MPEL NR) SJM Galaxy Wynn Resorts Steve Wynn/ Kazuo Okada MGM Resorts International Sheldon Adelson and Family Laurence Ho and James Packer Source: Company reports and Maxim Group estimates Wynn Macau and the Encore at Wynn Macau (expansion) MGM Macau Casino resort Sands Macau, Venetian Macau, Plaza Macau and Sites 5 & 6 Altira Macau, City of Dreams and Mocha Clubs Maxim Group LLC 15

16 Exhibit 13. Summary of Macau s Casino Operation Revenue EBITDA Receivables VIP Revenue $M % Market Margin % Market $M DSO $M % Market % by Junkets SJM (880-HK, NR) 9, % 9.2% 16.9% , % 90%-95% Galaxy (27-HK, NR) 5, % 14.0% 14.0% , % 90% Wynn Resorts (1128-HK, NR) 3, % 31.6% 22.7% , % 90% MGM China (2282-HK, NR) 2, % 24.3% 12.0% , % 90% Sands China (1928-HK, NR) 4, % 32.3% 29.9% , % 80%-85% Melco-Crown (MPEL NR) 3, % 6.0% 4.4% , % 90% Source: Company reports and Maxim Group estimates Company History After spending more than 20 years in Macau s gaming industry as a junket agent, first to STDM (the former entity of SJM) and later to Casino New Century and Waldo Casino, Lam Man Pou founded his own VIP gaming promotion business in May 2006 and recruited the now key members of top management. Subsequently, he and partners incorporated Asia Gaming & Resort Limited (AGRL) in Hong Kong to expand their VIP gaming business. In February 2010, AGRL was acquired by a Cayman Islands exempted company, CS China Acquisition Corp. (a special-purpose acquisition company) and subsequently changed its name to Asia Entertainment & Resources Ltd. (AERL). In July 2010, AERL was listed on the NASDAQ Global Market in the United States. Before the acquisition of AGRL, in August 15, 2008, the shell company, CS China Acquisition Corp., issued 4.8M units at $6 per unit in an IPO in the United States (each unit consisted of one ordinary share and two warrants, each entitling holders to purchase on ordinary share of AERL at $5). Combining 720,000 units over-allotment and 3.608M warrants ($0.50 per warrant) issued to the founders in a private placement, the net proceeds of the issuance was $33.28M, which was used as AERL s working capital after its acquisition by the shell company. It is worth noting that AERL s equity ownership of Macau s VIP gaming operation is based on a VIE (variable interest entity) structure, in which AGRL s wholly owned subsidiaries have all the economic interests of three Macau s VIP gaming promotion companies, Sang Heng Gaming Promotion Company Limited, Sang Lung Gaming Promotion Company Limited, and King s Gaming Promotion Limited, (Exhibit 7) through a series of contractual relationships. Maxim Group LLC 16

17 Management Profile Exhibit 14. Key Members of Top Management Name Title Experience Lam Man Pou Leong Hung Siak Li Chun Ming (Raymond) Chairman and Chief Marketing Officer Mr. Lam is the founder of AERL. He has been the chairman, chief marketing officer, and a director of the company since its inception in May From May 2006 to July 2007, he was the sole proprietor of Sang Heng and Spring, a gaming promotion business. From July 2004 through May 2006, Mr. Lam was a junket agent for Waldo Casino. From June 2002 through May 2005, he was a junket agent for Casino New Century. From March 1990 to May 2002, he was a junket agent for the Casinos of STDM. He is a member of the Macau Gaming Industry General Association of Administrators and VIP Gaming Promoters. CEO Mr. Leong served as the CEO and a director of the company since its inception in May From July 2006 to December 2009, he was chairman of Zhuhai Zhongzhu Real Estate Development Company Ltd. From July 2003 to June 2006, he was CEO of Idea Kids Toy Co. Ltd. and Genesis Industrial Co. Ltd., toy manufacturing companies in China and Macau, respectively. He became a management advisor to Mr. Lam in May 2006; meanwhile, he remained chairman of the two toy companies. From November 2001 through June 2003, Mr. Leong was CEO of National Craft Industrial Co. Ltd, a toys manufacturing company in China. CFO Mr. Li served as the CFO and a director of AERL since its inception in In May 2006, he became an advisor to Mr. Lam. From August 2005 through July 2006 he worked as a consultant for K Li Business Consultancy Limited, where he was engaged in the provision of corporate and financial advisory services. From July 1984 through July 2005, he worked as senior manager for Tony C. M. Yau & Company, a CPA firm in Hong Kong. Since August 2006, he has been an executive director of Klis & Associates CPA Limited in Hong Kong. Mr. Li is a member of the Hong Kong Institute of Certified Public Accountants. He is also an associate of the Hong Kong Taxation Institute and the Association of International Accountants. He is a graduate of Hong Kong Polytechnic University, Department of Accounting. Vong Hon Kun COO Mr. Vong served as the COO and a director of AERL since its inception in Mr. Vong joined Mr. Lam s gaming promotion business in May From July 2004 through May 2005, he was a junket agent for Waldo Casino. From June 2002 through May 2005, Mr. Vong was a junket agent for Casino New Century. From July 1990 to May 2002, Mr. Vong was a junket agent for the Casinos of STDM. Before he joined the gaming industry, Mr. Vong had worked as a civil servant for six years. He is a member of the Macau Gaming Industry General Association of Administrators and VIP Gaming Promoters. Source: Company reports Maxim Group LLC 17

18 Exhibit 15. AERL - Income Statement Q11 2Q11 3Q11 4Q Q12E 2Q12E 3Q12E 4Q12E 2012E 2013E $'s in millions, except per share data Full Yr Full Yr Full Yr Full Yr Full Yr 31-Mar 30-Jun 30-Sep 31-Dec Full Yr 31-Mar 30-Jun 30-Sep 31-Dec Full Yr Full Yr Revenue from VIP Gaming operations $ Y/Y growth 58% 41% 19% 110% 103% 83% 161% 62% 97% 37% 35% 15% 27% 27% 21% Q/Q growth -60% 8% 35% -6% -72% 6% 15% 3% Commission to Agents (18.3) (25.1) (39.1) (76.6) (31.0) (33.3) (47.2) (44.5) (156.0) (44.9) (47.8) (55.7) (57.7) (206.0) (252.9) as % of RCT 0.65% 0.78% 0.75% 0.73% 0.76% 0.77% 0.79% 0.80% 0.78% 0.80% 0.80% 0.81% 0.82% 0.81% 0.82% Gross Profit Gross margin 0.0% 0.0% 50.9% 35.3% 39.7% 39.5% 39.8% 36.6% 36.2% 37.8% 36.2% 35.9% 35.2% 34.6% 35.4% 34.6% SG&A (4.4) (5.5) (5.3) (11.2) (3.3) (4.2) (4.1) (4.9) (16.6) (4.5) (5.1) (5.6) (7.1) (22.2) (26.7) % of net revenues 0% 12% 10.7% 8.7% 8.9% 6.4% 7.7% 5.5% 7.0% 6.6% 6.4% 6.8% 6.6% 8.0% 7.0% 6.9% % of RCT 0.16% 0.17% 0.10% 0.11% 0.08% 0.10% 0.07% 0.09% 0.08% 0.08% 0.09% 0.08% 0.10% 0.09% 0.09% Special rolling tax (0.3) (0.5) (1.0) (0.4) (0.4) (0.6) (0.6) (2.0) (0.6) (0.6) (0.7) (0.7) (2.6) (3.1) % of net revenues 0.0% 0.0% 0.6% 0.9% 0.8% 0.80% 0.78% 0.80% 0.80% 0.8% 0.80% 0.80% 0.80% 0.80% 0.8% 0.8% Amortization of intangibles (0.8) (1.3) (1.3) (1.3) (1.3) (5.1) (1.3) (1.3) (1.3) (1.3) (5.1) (5.1) % of net revenues 0.0% 0.0% 0.0% 0.0% 0.7% 2.5% 2.3% 1.7% 1.8% 2.0% 1.8% 1.7% 1.5% 1.4% 1.6% 1.3% Total Operating Expenses (13.4) (23.0) (5.8) (5.8) (13.1) (5.0) (5.9) (6.0) (6.7) (23.6) (6.3) (6.9) (7.6) (9.0) (29.9) (34.9) Operating income including pre-acquisition Operating margin 41.6% 36.5% 39.6% 25.7% 29.4% 29.8% 29.0% 28.6% 26.5% 28.3% 27.2% 26.6% 26.4% 24.3% 26.0% 25.5% % of RCT 0.47% 0.63% 0.30% 0.36% 0.37% 0.37% 0.36% 0.33% 0.36% 0.34% 0.33% 0.33% 0.30% 0.33% 0.32% Prior owners' interest in pre-acquisition profit (9.5) (13.3) (20.2) (15.6) (4.3) Operating income attributable to ordinary shareh - (0.0) - (0.0) Change in fair value of contingent consideration (2.4) (2.1) 6.2 (1.0) (1.0) - Net Income - (0.0) - (0.0) Net margin 0.0% 0.0% 0.0% 0.0% 26.0% 25.1% 38.3% 36.1% 23.5% 30.8% 25.8% 26.6% 26.4% 24.3% 25.7% 25.5% Translation adjustment (0.0) (0.1) (0.0) (0.2) 0.2 (0.1) Total other comprehensive income - (0.0) - (0.0) Total other comprehensive income net m 0.0% 0.0% 0.0% 0.0% 25.9% 25.0% 38.3% 35.9% 23.7% 30.8% 25.8% 26.6% 26.4% 24.3% 25.7% 25.5% GAAP EPS (basic) 0 ($0.00) $0.00 ($0.00) $2.33 $0.37 $0.54 $0.69 $ 0.46 $2.07 $0.49 $0.53 $0.61 $0.58 $2.20 $2.65 GAAP EPS (Diluted) $0.00 ($0.00) $0.00 ($0.00) $1.88 $0.37 $0.54 $0.68 $ 0.41 $2.00 $0.47 $0.51 $0.58 $0.55 $2.11 $2.55 Y/Y growth NM 19% 11% 29% -27% 6% 28% -6% -15% 36% 6% 20% Basic shares Diluted shares D&A Stock-based compensation EBITDA Margin 42% 37% 40% 26% 30% 32% 31% 30% 28% 30% 29% 28% 28% 26% 28% 27% Y/Y Growth 39% 52% -23% 145% 71% 82% 200% 72% 99% 23% 22% 6% 15% 16% 18% Source: Company reports and Maxim Group estimates. Maxim Group LLC 18

19 Exhibit 16. AERL Balance Sheet $'s in millions, except per share data E 2013E Assets Cash and cash equivalents $ 0.3 $ 13.8 $ 16.7 $ 29.2 $ 16.6 Accounts receivable, net Markers receivables Advance to owner-pre-acquisition 1.5 Prepaid expenses and other assets Total current assets Intangible assets Goodwill Property and Equipment Other assets Total Assets $ 2.8 $ 4.9 $ 11.3 $ 6.3 $ $ $ $ Liabilities and Shareholders' Equity Lines of credit payable $ 2.6 $ 11.8 $ 46.3 $ 65.2 $ 86.0 Accrued expenses Payable-King's gaming acquisition, current portion Loan payable, shareholders, current Total Current Liabilities Loan payable, shareholders Long-term payable-king's gaming acq Total liabilities Preferred shares Ordinary shares Additional paid-in capital Retained earnings (0.0) Accumulated other comprehensive income (1.5) (0.0) (0.1) (0.1) (0.1) Total Shareholders' Equity (1.5) Total Liabilities and Shareholders' Eq $ 3.1 $ 4.9 $ 11.3 $ 6.3 $ $ $ $ Source: Company reports and Maxim Group estimates. Maxim Group LLC 19

20 Exhibit 17. AERL - Cash Flow Statement $'s in millions, except per share data E 2013E Cashflows from Operations Net Income $ - $ (0.0) $ 33.0 $ 77.3 $ 82.0 $ 98.8 Adjustments for: Amortization of intangible assets Change in fair value of contingent consideration for the acquisition of King's Gaming - (6.2) (8.0) (9.6) Depreciation Change In Assets & Liabilities Accounts receivable 1.4 (1.3) (6.4) 9.6 (0.3) (0.3) Markers receivable (120.1) (119.9) (98.2) (107.7) Advance to owner pre-acquisition (5.4) Prepaid expenses and other assets (2.1) 2.1 (0.1) (0.2) - - Lines of credit payable Accured expenses Total Cashflows from Operations $ 1.5 $ 1.9 $ 0.6 $ 3.9 $ (76.5) $ 5.28 $ 3.9 $ 11.3 Cashflows from Investing Activities Purchase of property and equipment (0.0) Cash paid for acquisition - - (9.0) - (9.0) (9.0) Total Cashflows from Investing Activiti $ - $ - $ - $ - $ (9.0) $ (0.0) $ (9.0) $ (9.0) Cashflows from Financing Activities Ordinary shares issued for cash Redemption of warrants for cash (0.0) Cash dividends paid (3.9) (12.3) (14.8) Net distribution to prior owners of interest in pre-acquisition profit (0.3) (4.3) Subscription receivable collected 0.0 Shareholder loans, net Proceeds from merger Proceeds from stock/convertible loans Total Cashflows from Financing Activit $ (1.5) $ (1.5) $ (0.3) $ (4.3) $ 99.0 $ (2.3) $ 17.7 $ (14.8) Effect of exchange rate changes 0.1 (0.0) (0.0) (0.1) (0.1) (0.1) Net (decrease) increase in cash (0.4) (12.6) Beginning Cash (0.4) Ending Cash Before Incremental Borro $ 0.0 $ 0.4 $ 0.3 $ (0.4) $ 13.5 $ 16.7 $ 29.2 $ 16.6 Source: Company reports and Maxim Group estimates. Maxim Group LLC 20