Its primary business is real estate development and owner of Commercial Office and Retail real estate assets in HK and China. On the development side, it is one of Hong Kong largest developer. On balance sheet, it also owns some of the best commercial office towers in Hong Kong including International Commerce Center (ICC) and International Financial Centre Complex (IFC1 and IFC2).
Company earnings hence is a mixture of development profits and rental income. It has shifted portion of operation to China and focus on development in Tier 1 cities only (e.g Shanghai and Guangzhou).
The direct real estate assets on balance sheet provides steady cash flow and the residential development business earnings while is more volatile allows the reinvestment of rental income more opportunistically.
The company is currently run by a professional management team headed by the son of the founder. It is the largest listed Real Estate company in Hong Kong and the founding family owns more than 30%. While this align the incentives of the management and shareholders there might be scandals that shows cracks in the optically nice governance structure. However this is the risk in investing in Asia.
From Australian investors perspective, the business model is comparable to Mirvac (ASX MGR).
Recent weak Chinese economic data reinforced market apprehension that future growth trajectory will be lower than recent experience. They key source of weakness being the residential real estate market. As a result, Hong Kong listed Real Estate developers which almost all have exposure to China were sold off indiscriminately.
Our position is an attempt to catch a falling knife. Our thesis is that while there are certainly risks in residential development business of a number of listed companies in HK. SHK represent the best of breed. Management has a history of developing world class commercial assets. Its own on balance sheet assets represent some its best quality products. It is widely recognized that ICC and IFC2 are some of the best commercial office buildings in Asia.
Discount to Book Value and Balance Sheet
The business is trading below the Net Asset Value. The most recent annual report showed that the NTA is at least $160 HKD a share. Our entry price of $90 HKD represent a material discount to book value. Now we could be wrong and market expectation of write down does materialize.
But debt on balance sheet is only ~10% gearing and rental income from investment property ensure that debt coverage ratio can be maintained at investment grade. The business will withstand any sector collapse and be better positioned relativity compared to its over levered competitors in Hong Kong and China.
Residential business will experience slowdown but it will not hemorrhage losses as the market expects.
Unlike a REIT listed in Australia or US where typical payout ratio of above 90% is quite common. Currently 16.HK payout ratio is closer to 50%. We see potential increase in future dividends even with a slow down in earnings growth. Given the 16.HK is trading at a large discount to book value. Capital management could also be an option. However our base case is not dependent on either dividend increases or share buyback.
The Key driver of investment return would be a recovery in the Tier 1 Chinese real estate market. However given the slowdown is not new news for investors and positive signs year to date of price increase in Tier 1 cities. We are growing increasingly confident of our position.
As our entry price is at a severe discount to book value with a positive ROE. We are willing to be patient and wait for a recovery in sentiment.
It is expected that standard of disclosure is sub optimal compared to developed markets. However the lack of property information for on balance sheet items is concerning.
For example ICC and IFC are two of its largest assets however there is no disclosure on Net Property Income, cap rate or a breakout of individual assets that make up the investment property book value. Or segment split between development assets and completed investment properties.
However we estimate that given these assets are valued by professional valuers like Knight Frank and signed off by directors that they are at least realistic. The discount of trading price verse book value gives us a greater level of comfort. The business is trading at a discount because of wider macro concerns on the development business side not potential impairments on the investment properties.
Hong Kong dollar is pegged to US dollar. Hence overall equity returns will be impacted by fluctuation in the au dollar to us exchange rate.
Disclosure and governance usually goes hand in hand. SHK can be considered to be one of the better managed HK developers, miles ahead of the Chinese listed developers in Hong Kong.
However there is still wider concerns on governance. After all the joint managing director was found guilty of corruption in a widely reported corruption scandal. The realist in us sees it as a cost of investing where there will always be hiccups in management and governance. While not preferred, we see the risks to manageable given the large stake of the founding family.