Lottvision @ 58.5 cts ( Gaming / China ) 1 comments

Final Poll Results: 16:4

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Main issues

1.Overvalued concept stock

Gaming in the biggest potential market in the world ---- that sounds like a potent combination and perhaps it is what has propelled Lottvision to its current dizzying heights from the 10 cents just early in Jan 07 --- a quintupling in market value.

The company was previously known in its previous incarnation as Multivision, where it specialised in surveillance camera systems. It had been quiet ever since it sold off most of its surveillance systems business in early 2006 (distributing a one-off dividend to shareholders from the sale); now although it still has a surveillance system division, the company has professed that it is concentrating on expanding the lottery business in China.

In view of the fact that (1)the surveillance system business has had an unsteady earnings track record since the main arms were disposed of, and reported losses in the most recent 3Q07, and that (2)the company does not appear keen to focus its efforts on this business further, we can at most measure the value of the business by its tangible book value. Excluding the substantial "intangible assets" (no longer relevant since they do not value-add if Lottvision do not plan to grow further) and interest in PAL (the lottery arm), the surveillance system division is at most worth about 10 cents/share according to the accounts.

And that means the interest in PAL is valued at nearly 50 cents/share currently. PAL in its present form operates mainly in China, with a 51% stake in the leading domestic lottery terminal distributor, a 100% subsidiary providing venue management consultancy services to domestic lottery centres, and a 60% stake in a JV to develop interactive mobile lottery games. The entire premise of Lottvision's upward surge recently is, I believe, due to a restructuring that has turned a JV relationship between Lottvision and Melco in the form of PAL, into an ownership structure where Melco effectively controls Lottvision as the latter's largest shareholder. Melco is of course the listed group vehicle of Macau tycoon Stanley Ho.

Many believe that Stanley Ho's involvement will add tremendous value to the group. He certainly has connections and track record. Indeed, part of the reason for Lottvision's strong surge is the sudden realisation of Stanley Ho's involvement, even though technically, Melco was already linked with Lottvision in the PAL venture last September when the JV was first set up. Melco's vehicle in the JV then was via Bright Ally, which is why nobody realised the link.

What are my reasons for calling a hotstocknot then? It all boils down to valuation. As analysed above, the 50ct/share valuation for 70% of PAL (the other 30% directly under Melco) under the new structure suggests that this 70% stake is considered by the market to be worth $300M, based on 620M shares (including the 176M new shares to be issued to Melco in the restructuring). And all this for an operation that, from inception in September-December 2006, incurred a loss of HK$3.5M. This is one hell of a concept stock.

How can one justify paying this kind of money for a money-losing operation? It is of course easy to tell me not to be myopic and that I should instead focus on the size of the Chinese lottery market and the high annual growth rate of 30-40%, and the personal influence of Stanley Ho. But look at it this way: out of the three operating arms of PAL, the venue management consultancy arm has only recently started, and the technology solution venture is work-in-progress; this leaves BTI--- the lottery terminal division as the only mature lottery operating business in PAL. It supplied 60% of the lottery terminals purchased by China's sports lottery administration centre ..... and PAL still made a loss? That is surely a statement about the profitability of the business!

Another possibility, of course, is that the operating expenses for starting up the other two arms are sucking up funds. If so, where is the break-even point? That is the classical problem with concept stocks: there is a lack of clarity about when the business reaches a self-sustaining stage, a situation which actually encourages heavy trading and speculation (there is evidence that the more unclear an outcome, the more likely people are to trade); the problem is: one doesn't know when the music stops.

Can anybody tell me how to value PAL's business? I seriously doubt so. Lottvision/Melco are certainly not going to be allowed to operate lotteries in China under the present lottery system (only two state agencies are allowed to do so); they can only participate via provision of related services (eg. venue management) and products (eg. terminals, software platforms). It hardly suggests any kind of monopolistic advantage; if foreigners are now allowed to operate casinos in Macau and compete with Stanley Ho, surely the path is open for them to provide related services/products in mainland China under a deregulating regime (eg. Tabcorp entered JV to provide support for China's lottery market - Jun 2005). Lotteries are rather mature in the three main cities of Guangzhou, Shanghai and Beijing, and expansion is expected to be driven by growth in regional provinces; however distribution costs would be higher in these areas. This is not a Genting IR-type venture where the development is ground-breaking, receives support from the government and is guaranteed a duopoly for ten years; the PAL business is supporting an industry that is actually not new in China (lotteries have been around since the 1980s), experiences (undefined) competition in its products/services, and is loss-making with no guarantee of a turnaround in the near future.

And Legg Mason is buying aggressively into it? Perhaps the right conclusion to draw is that their accumulation explains why the stock's price has been rising, rather than that one should buy in because Legg Mason is buying.

References:
(1) Lotteries and Gambling in China: A Market Analysis 2002

Poll
I agree that Lottvision is a hot-stock-not: Agree/Disagree