Disclaimer: This is a relatively low liquidity idea, with about a $50m tradable float and about $25k/day average volume.  However, if you think you might be interested in a stock trading at less than 25% of liquidation value of a portfolio of geographically diversified high quality assets, just above net cash, and about 6x FCF with a long-term value-oriented management team reinvesting that cash flow at unlevered IRRs in the high teens over the past decade, all while collecting a nice 4% growing dividend yield, read on…

Keck Seng Holdings (184:HK) is a diversified real estate investment holding company with assets in Vietnam, Macau, the United States, Japan, China, Canada and Singapore.  We believe that the stock has the potential to be a multi-bagger over the next 5 years, while the near-term downside is well protected with unencumbered cash effectively greater than the market cap, cash net of total liabilities at 67% of the market cap, and a 16% recurring FCF yield with strong fundamentals driving organic growth.

Investors benefit from a substantial margin of safety at current prices, given the collection of assets on the balance sheet conservatively worth more than 4x the market cap:

Before we go further, we should address the concern of management quality.  Keck Seng is majority owned and run by three brothers, who inherited the stakes from their father, Ho Yeow Koon, who founded the Company during WWII in Singapore.  Mr. Ho was born into poverty in mainland China in 1920 and arrived in Singapore in 1939 penniless.  The Company was originally founded to transport produce from Indonesia to Singapore, and over the years, it gradually grew into palm oil plantations and property development and investments across Southeast Asia.  In 1980, Mr. Ho acquired control of a small listed company in Hong Kong to use as an investment vehicle (think Berkshire Hathaway).

The full story is quite interesting and can be found here in an interview with the founder:

https://www.dropbox.com/sh/stmfy5fvf8ktzow/6z6mcdDE5H

There is one other listed Keck Seng in Malaysia, with operations located primarily in Singapore and Malaysia.  As far as we can see, there have been no connected transactions between the two companies and no overlap of any assets.  The only connection between the two entities asset-wise is that the Malaysian listing does hold minority stakes in the two Canadian hotels listed above, in which the Hong Kong listing is also a minority investor.  All hotel and property-related investments in the Malaysian company were made prior to 2002, as far back as we can find information online, so it appears that the Hong Kong listing is the sole vehicle for new property investment deals.  It’s likely that some of these deals were made very early on by the founder before he passed.

Management of the two companies and their various subsidiaries is split between the numerous offspring Mr. Ho left behind, while the eldest sons hold controlling stakes and executive director positions in each company.  There is one executive director of the Hong Kong listing, Paul Tse, who is not part of the Ho extended family.  We believe that Mr. Tse has been instrumental in overseeing the Hong Kong listing’s successful investments in Macau as well as the Group’s activities in the United States and Japan.

Our focus on Hong Kong listed Keck Seng is due to much more attractive underlying assets (hotels and investment properties generating recurring FCF), a much wider discount to net asset value, and a superior investment track record over the past decade, as seen below:

(Note: All numbers include minority interests and exclude revaluation gains for accurate ROC numbers, in HK$ millions)

Year                       Revenue (% Recurring)     EBIT                        Equity                   Net Cash                Pre-tax ROC      

2001                       246 (21%)                            35                           1,493                     (372)                      1.9%     

2002                       224 (32%)                            35                           1,493                     (290)                      2.0%

2003                       339 (34%)                            50                           1,517                     (190)                      2.9%

2004                       403 (60%)                            122                         1,625                     29                           7.6%

2005                       586 (69%)                            190                         1,775                     377                         13.6%

2006                       628 (84%)                            241                         1,995                     647                         17.9%

2007                       638 (96%)                            317                         2,261                     982                         24.8%

2008                       807 (90%)                            294                         2,462                     1,192                      23.1%

2009                       890 (95%)                            349                         2,722                     711                         17.4%

2010                       1188 (91%)                          362                         3,017                     668                         15.4%

2011                       1182 (99%)                          295                         3,081                     620                         12.0%

2012                       1363 (90%)                          511                         3,437                     1,385                     24.9%

As you can see from the table above, the Group has been generating double digit unlevered returns on capital across their portfolio of investments since 2005, while the quality of revenue has vastly improved to the point where nonrecurring property sales make up less than 10% of total revenues.  The trend of increasing return on capital over time can be attributed to income growth in Vietnam, Macau, and the U.S. from assets that have either been held at cost or depreciated.  The dip in return on capital from 2009 to 2011 can be attributed first to the acquisition of the W San Francisco halfway through 2009 resulting into partial operating results for the year over the full purchase price, and second to the acquisition of an apartment block in Japan at a single digit cap rate (the block was subsequently sold at a significant profit and very attractive IRR, but this does not appear in these numbers).

Along with the growth in revenue from recurring hotel operations and rental income, there has been significant free cash flow growth as well.  The following table shows the annual FCF net to Keck Seng, after minority interests and capital expenditures are taken out:

Year                       Recurring FCF Net to Group (HK$m)              Dividends Paid                      Payout Ratio

2005                       30.1                                                                   27                                           90%

2006                       39.5                                                                   44                                           111%

2007                       63.2                                                                   57                                           90%

2008                       173.7                                                                 59                                           34%

2009                       183.7                                                                 68                                           37%

2010                       207.2                                                                 68                                           33%

2011                       151.9                                                                 43                                           28%

2012                       267.8                                                                 68                                           25%

The Group’s impressive growth in FCF is partly due to the acquisition of the W San Francisco in 2009 and properties in Japan in 2010 and 2012, but also due to organic growth in Vietnam, Macau, and the U.S.  The decline in 2011 is mainly due to renovation capex for the W San Francisco and a one-off tax adjustment in Vietnam.  We can also see from this table that the dividend is fully supported by recurring FCF with substantial room for future increases.  The current dividend yield is about 4%.

And now on to an overview of the Group’s core assets:

Macau

Keck Seng has been active in Macau since 1977.  Over the years, the Group developed and sold a number of apartment blocks in stages in Ocean Gardens, which is located in Taipa just across the bridge from the original gaming district on the Macau peninsula and just north of the new casino developments on the Cotai Strip:

http://www.oceangardens.com.mo/English/OG/og-location.htm

The Group’s business model in Macau began to shift from “build to sell” to “build to hold” around 2002 when Stanley Ho lost his gaming monopoly and licenses were awarded to foreign operators.  It soon became clear that these operators had big plans for development in the newly reclaimed Cotai area, and Ocean Gardens was perfectly positioned to benefit from the inevitable rise in incomes and real estate asset values.  The Group’s development of Sakura, Lily, Aster, and Bamboo courts utilized the remainder of Keck Seng’s waterfront land and was almost perfectly timed with the bottom of an 8 year bear market in Macau property, with prices down as much as 60% from their 1996 peak.  A building boom funded by mainland hot money flows during the early 1990’s resulted in a massive glut of supply, and very few new developments were built in the following decade.

From 2004 to 2013, average real estate values in Macau and Taipa rose roughly 10-fold.  Government statistics on real estate transactions can be found here:

http://www.dsec.gov.mo/TimeSeriesDatabase.aspx

Although the Company leases most of its property in Macau, vague language in the Hong Kong Accounting Standards allows the Company to hold the following properties at cost as “Properties Held for Sale:”

Property Name                 Square Meters                     Units                        Type                                    Ownership        

Ocean Industrial                2,129                                     3                              Industrial                             100%    

Rose Court                        1,033                                      3                              Residential                          70.61%

Begonia Court                    980                                        4                              Residential                          70.61%

Orchid Court                       490                                        2                              Residential                          70.61%

Sakura Court                      8,265                                     24                            Residential                          70.61%

Lily Court                            4,739                                     28                            Residential                          70.61%

Aster Court (Lot W)            10,517                                   40                            Serviced Res.                      70.61%

Bamboo Court (Lot W)        10,517                                   40                            Serviced Res.                      70.61%

All residential and serviced residential properties are located in Ocean Gardens.  From 2008 (when the segment data became available) to 2012, the Group was selling these apartments at a significant premium to their development cost:

Year                       Revenue                                 EBIT                       Mark-up at sale                     Price/sqm ($HK)

2008                       82                                           67                           5.5x                                        47,436

2009                       32                                           25                           4.6x                                        62,603

2010                       106                                         88                           5.9x                                        67,890

2011                       17                                           14                           5.7x                                        49,437

2012                       130                                         107                         5.7x                                        53,634

The apartments sold were actually fetching a premium to average market values over this period, which we believe was due to the units being located on the higher floors of Sakura Court, one of the newest blocks with excellent sea views.

Management decided to stop selling apartments after H1 2012, in anticipation of higher prices following the completion of the HK-Macau bridge, the Light Rail Transit with a stop at Ocean Gardens, and a number of large casino developments due to be completed in 2015-2016.  According to the government statistics, average prices have since risen by roughly 50% (in HK$):

Period                  Avg. Price/sqm – Macau                      Avg. Price/sqm – Taipa                       Avg. Price/sqm OG*

Q1 2012                45,453                                                   48,107                                                   41,319

Q2 2012                55,427                                                   66,804                                                   42,510

Q3 2012                58,305                                                   67,579                                                   48,183

Q4 2012                64,869                                                   67,218                                                   58,458

Q1 2013                77,975                                                   71,474                                                   55,605

Q2 2013                88,957                                                   83,176                                                   65,337

Q3 2013                66,936                                                   70,229                                                   49,078

Q4 2013                85,974                                                   96,061                                                   64,719

*Second Hand Ocean Gardens transactions

In our estimate of fair value for the Ocean Gardens residential properties, we use a price/sqm in line with the average Ocean Gardens transaction price, which we think is likely too low given that the properties in question are mainly located in the newest blocks facing the ocean.

We use a higher price/sqm for the Lot W serviced apartment blocks.  Our conversations with another listed property investment fund in Macau lead us to believe that whole serviced apartment blocks are extremely rare.  Foreign REITs or other large property investors looking to invest in Macau thus have very limited options and would have to pay a premium for a whole block.  Our price/sqm is therefore in line with average transaction prices in Macau and Taipa, although again we think this is conservative given the rarity, location, and condition of the property.

Our conservative estimate of the value of the Group’s properties held for sale are as follows:

Property                                         Area (sqm)           Price/sqm($HK)                Total(HK$m)         Group Interest

Ocean Industrial                              2,129                     33,721                                 72                           72

Lot W Serviced Apts                        21,034                    82,022                                1,725                      1,218

Other Residential                            15,507                     59,250                                919                         649

Total                                               38,670                                                              2,716                     1,939

It is very important to point out that these properties, conservatively worth HK$2.7 billion, are held on the balance sheet at only HK$283 million! Once the Company decides to start selling properties again, we will very likely see 90%+ operating margins in the property development segment.  As our investment thesis is based on the stock’s low valuation in relation to the Company’s recurring FCF, this is really just icing on the cake if it ever materializes.

The Group’s investment properties in Macau are as follows:

Property Name                 Area(sqm)                           Units                        Type                      Ownership

Luso Bank Building             2,811                                     40                           Office                     100%

Ocean Plaza                       8,782                                     47                           Retail                     70.61%

Ocean Tower                      4,618                                     19                           Office                     70.61%

Average prices of office and retail space in Macau have witnessed a similar meteoric rise in the past decade, driven by dramatic increases in underlying rents as well as booming demand amid ever constrained supply.  Again using conservative estimations against the most recent average transaction price statistics, we arrive at the following estimates of fair value:

Property                             Area (sqm)           Price/sqm($HK)                  Total(HK$m)        Group Interest

Luso Bank Building              2,811                     74,525                                   209                         209

Ocean Plaza                        8,782                     45,000                                   395                         259

Ocean Tower                       4,618                     55,000                                   254                         179

Total                                   16,211                                                                858                         647

Again, it is important to point out that the Company marks fair value of these properties at roughly HK$466m, leaving substantial upside to our conservative fair value estimate.  We think that management is being overly conservative here in a rapidly rising market so that they would not have to report losses in a down market.  Ocean Plaza and Ocean Tower are unique assets given that there are no other comparable properties in the vicinity of Ocean Gardens, so perhaps it is passable to the Company’s auditors to use a DCF valuation using very conservative forward assumptions about rental increases and cap rates.  However, looking backwards, the Company was able to increase their rent per square meter by more than 200% from 2007 to 2012, which is about in line with the overall market:

Year                       Macau Rental Revenue (HK$m)                           Total Area (sqm)                 Annual Rent/sqm(HK$)

2007                       19                                                                           61,250                                   310

2008                       34.4                                                                        59,522                                   579

2009                       30.4                                                                        59,178                                   514

2010                       39.6                                                                        57,617                                   688

2011                       41.5                                                                        57,274                                   724

2012                       60.7                                                                        54,858                                   1,106

Outsiders without intimate knowledge of what’s happening in Macau may take one look at the sharp rise in asset values and low cap rates and quickly come to the conclusion that it’s a bubble waiting to burst.  We tend to lean towards the camp that thinks there is more upside to come.  As dramatically as the small territory has changed in the past decade, the changes coming in the next five years could prove to be even more dramatic.  A map of the major infrastructure projects in the works can be found here:

http://www.mpofund.com/macau_location.php

The scheduled completion of the bridge to Hong Kong Airport in 2016 will coincide with the completion of several new enormous casino developments and an expansion of hotel capacity by more than 100%.  Not only will the bridge make Macau substantially more accessible to the 2 billion people living within a 3 hour flight, the greatly expanded hotel capacity will enable the Chinese government to extend travel permissions to more of the population (currently only 1/3 of the population is permitted to travel to Macau, and hotel occupancy still runs at 88%!).  Imagine the pent-up demand in the other 2/3 of the country that’s just waiting to be unlocked.  The expanded capacity will also drive growth in the nongaming sectors of the economy, such as conventions and family-oriented tourism, with a 1.2m sq. ft. convention center already complete as part of the Venetian and the Chimelong Ocean Resort opening in stages starting last year.

This is also not a case of hot money flows pushing up prices; more than 90% of buyers are locals.  Gross national income has nearly tripled since 2002, average household mortgage debt stands at only 21% LTV, and average prices are still at about a 60% discount to Hong Kong, despite higher incomes.

Total Macau Value (Group’s Share): HK$2,586m

Sources:

http://www.dsec.gov.mo/TimeSeriesDatabase.aspx

http://www.oceangardens.com.mo/English/OG/og-main.htm

http://lotw.oceangardens.com.mo/mavista/cms/en/home

http://www.scmp.com/article/478963/soft-rental-market-reins-macau-property-spiral

Vietnam

The Group’s investments in Vietnam are comprised of a 25% minority stake in the historic Caravelle Hotel and a 64% stake in the adjacent Sheraton Saigon, which the Group developed in a joint venture with the government. 

Originally, the Sheraton Saigon was a combination of serviced apartments, which commenced operation in 2002, and a hotel, which opened at the end of 2003.  The development was the largest hotel/apartment/commercial complex at the time.  In 2007-2008, the serviced apartments were converted to add 112 hotel rooms.  The complex also houses a small casino with electronic game tables and slot machines, which generates about 50% of total revenues.  Since 2003, Vietnam has allowed foreigners to operate gaming facilities within 4-star and 5-star hotels.  Currently, only foreign passport holders are legally allowed to gamble, but there has been talk recently of legalizing gambling for locals in order to attract investment from major foreign gaming operators.  The complex has performed quite well throughout the global financial crisis in terms of EBITDA and FCF, thanks to stable gaming revenues and a recovery in occupancy rates.

(In HK$ millions except for ADR)

Year                       Total Revenue       Net Slots Rev.         EBITDA                 FCF - Group            Occupancy             ADR      

2002                       14.2                        0                              6.8                          -4.3                        NR                           NR

2003                       65                           0                              19.2                        -37                          NR                          NR

2004                       182                         0                              81.7                        41.1                        68%                       $100

2005                       339                         123                         130.5                      71.6                         77%                       $123

2006                       460                         214                         164.3                      87.7                         69%                       $152

2007                       530                         226                         208                         104.7                      78%                        $189

2008                       624                         288                         241.9                      103.3                      65%                        $223

2009                       601                         339                         216.1                      117.8                      52%                        $184

2010                       617                         321                         225.9                      122.4                      64%                        $165

2011                       629                         323                         230.5                      75.1                        70%                        $170

2012                       638                         331                         278.2                      142.6                      68%                        $170

Free cash flow has grown consistently in every year except 2008 and 2011, due to capex for the renovation in 2008 and a one-off tax adjustment of about HK$60m in 2011.  The Vietnamese economy is going through a prolonged period of consolidation after the debt-fueled real estate and stock market bubbles popped, and competition in Ho Chi Minh (Saigon) has heated up, forcing hotels to keep their prices low.  The Sheraton Saigon should continue to at least tread water in the foreseeable future due to its central location and steady gaming revenues, and it will possibly see a bump in occupancy in H1 2014 as the rival Park Hyatt across the street closes for renovations.

It’s worth briefly mentioning the slot machine malfunction lawsuit that was recently dismissed.  In 2010, a slot machine in Sheraton Saigon’s Palazzo Club glitched and displayed a US$55m win, despite the maximum win amount for the machine being US$46,620.  This type of glitch is not uncommon in casinos, and there is a clear legal precedent around the world of such cases being settled for small amounts.  It was therefore a bit shocking when the district court ruled in favor of the plaintiff, awarding him $55m in early 2013.  Of course, the Group appealed the case to a higher court.  Although rule of law can be a bit spotty in Vietnam, to say the least, the Group had two very powerful cards to play.  For one, as this casino was operated by a joint venture with the government, it was very hard to see a high Vietnamese court actually ruling in favor of a plaintiff suing the government for such a large amount.  Secondly, as the government was and still is desperately trying to attract investment from foreign gaming operators, the court was likely advised that an adverse ruling that would scare off potential foreign investors would be far from ideal.  We’re not entirely sure what went on behind the scenes, but in January 2014, the plaintiff withdrew his case with no payment required from the Group and the district court ruled to cancel its previous decision.

Based on our discussions with a London-listed Vietnamese real estate fund manager, cap rates for hotels and office properties in Ho Chi Minh are generally around 10%.  In the interest of conservatism, we have used a 10% FCF yield to estimate fair value.  We think this is appropriate as FCF has continued to grow in US dollar terms despite economic difficulties over the past 5 years, and the hotel is well positioned to benefit if the government legalizes gambling for locals or the economy returns to healthy growth.  For the Caravelle, we are even more conservative, using a 10% net income yield (due to Group’s minority interest, financials are not consolidated).  The Group has recouped its entire unlevered investment from cash inflows over the life of the development, and our valuation assumptions puts the Group’s IRR at about 18% annually over the past decade.

Total Vietnam Value: HK$1,547m

Sources:

http://www.tripadvisor.com/Hotels-g293925-zfc5-Ho_Chi_Minh_City-Hotels.html

http://www.eturbonews.com/37438/fewer-tourists-more-competitors-ho-chi-minh-city-hotels

http://www.businesstraveller.asia/asia-pacific/news/park-hyatt-saigon-announces-renovation-project-

http://vietnam-gaming-news.blogspot.hk/2010/06/lawsuit-for-us55-million-of-game.html

http://www.sheratonsaigon.com/

United States

Cash rich from Macau property sales and surging free cash flow from the Sheraton Saigon, Keck Seng was able to take full advantage of the bursting of the real estate bubble in the United States in 2009, stepping in at the height of fear to make the first hotel acquisition in San Francisco since 2007.  The Group purchased the W San Francisco from Starwood, which was in a rush to deleverage its balance sheet while many of the REITs and private equity firms that would normally be active in this market were on their knees, crippled by overleveraged balance sheets, falling asset prices, and difficult financial markets. 

Keck Seng paid US$90 million (HK$695m) for the 404-room hotel, amounting to about $220,000 per key.   The purchase price translated to an eye-popping 15.1% cap rate based on 2008 net operating income, but due to a significant drop in room rates and occupancy in the midst of significant economic uncertainty and a lack of comparable transactions, Starwood was forced to part with the property at a valuation based on significantly depressed operating results.  In the valuation report, PKF explains that they had to throw out the sales comparison approach as all comparable sales occurred prior to 2008, and “the lack of debt capital available in the marketplace today has placed downward pressure on property values.”

http://www.keckseng.com.hk/Files/Announcement/2009/LTN20090727320.pdf

PKF subsequently could only use the income capitalization approach.  According to the valuation report, PKF’s valuation was based on a first year net operating income (EBITDA) of HK$42 million, 3% inflation and a 9.5% terminal capitalization rate.  Net operating income has more than doubled since the transaction, recovering to 2008 highs, and the market for hotel transactions is booming once again.

Before Purchase (HK$ millions)

After Purchase (HK$ millions)

The San Francisco lodging market has maintained one of the highest occupancy rates among U.S. markets while posting double digit ADR growth in each of the past three years.  On the demand side, both domestic and international tourism are booming, the economy is thriving due to the booming tech industry, and the newly renovated Moscone Center is planning another major expansion to meet growing convention demand.  On the supply side, San Francisco is possibly one of the tightest in the world, adding only 22 rooms of new supply since 2008, with only one 174-room limited service hotel currently under construction due to open this summer and one recently approved 250-room limited service hotel scheduled for completion by the end of 2016.  Due to scarcity of land and high barriers to new construction, total supply will likely stick around 34,000 for the foreseeable future.

It appears that the W San Francisco should be well positioned for further growth in revenue per average room (RevPAR) and EBITDA.  The full service hotel is located right across the street from the Moscone Center, which allows it to enjoy much higher than average occupancy and room rates throughout the year.  EBITDA margins will likely expand as revenues grow faster than operating costs.  The hotel completed a substantial renovation in early 2012, so capex over the medium term should be minimal.

We have three ways to value the W San Francisco: replacement value, comparable sales, and income capitalization.

Replacement value is at least $400,000 per key, about $162m (HK$1,250m), according to an analysis done in 2010:

“Case in point is the 423-room W San Francisco hotel that Starwood Hotels & Resorts Worldwide sold last summer for $90M, or $212,765/room to Keck Seng Investments of Hong Kong. To develop a similar hotel would cost at least $400,000/room, excluding the costs for the hotel’s restaurants, meeting rooms and other facilities, according to Alan X. Reay, head of the hotel brokerage and research firm Atlas Hospitality Group of Irvine, Calif.”

http://crystalinvestment.wordpress.com/2010/05/07/hotel-cap-rates-hold-firm-as-investors-change-approach/

While the San Francisco hotel market has been quite active in recent years, it is difficult to find a transaction that is really comparable to the W as it enjoys significantly higher than average occupancy and room rates due to its location and positioning.  Recent comparable San Francisco hotel transactions below (in US$):

Perhaps the most comparable transaction in this table is the most recent sale of Mark Hopkins by Intercontinental Hotels Group.  The hotel is roughly a mile away from the W San Francisco and is about the same size room-wise with similar market positioning.  However, the W San Francisco is generating roughly 25% higher RevPAR, and Mark Hopkins will undergo a $20m renovation this year which pushes up the purchase price substantially.  Therefore, if we assume a 25% higher price per key we get to $158m (HK$1,225m), and if we add another $20m we get to $178m (HK$1,380m).

Based on recent transactions, the W San Francisco could achieve an even sales price based on the income capitalization method.  Transactions of similar downtown hotel assets have been at cap rates around 5%.  A 5% cap rate on our 2013 EBITDA estimate of $14.2m (HK$110m) would result in a $284m (HK$2,200m) total valuation.  At the absolute low end, an 8% cap rate would result in a $177m (HK$1,375m) total valuation.

It is also important to note that the Company used $54m (HK$418m) of mortgage debt to finance the purchase in 2009, which has now dropped to $42m (HK$330m).  Based on $35m of equity invested plus an additional $7m of renovations, the Group has generated a levered IRR over the life of the investment of 34%-48%, depending on how you choose to measure the current valuation.  Unlevered IRR would range from 12% to 24%.

Total U.S. Value:  HK$1,400m (upside to HK$2,200m)

Sources:

http://news.theregistrysf.com/east-coast-reit-acquires-interest-fishermans-wharf-hotel-132mm/

http://news.theregistrysf.com/sunstone-to-acquire-hyatt-regency-in-san-francisco-for-262mm/

http://news.theregistrysf.com/mark-hopkins-hotel-sold-4-cap-rate/

http://news.theregistrysf.com/lasalle-buys-third-san-francisco-hotel-this-month/

http://www.dailyfinance.com/2012/10/25/pebblebrook-hotel-trust-acquires-the-hotel-palomar/

http://www.bizjournals.com/sanfrancisco/news/2013/01/10/webcor-general-contractor-moscone.html?page=all

http://www.us.jll.com/united-states/en-us/Research/Hotel_Intelligence_San_Francisco_July_2013.pdf

http://marketing.cbre.com/IGMC/CapRate_Feb2013/2H_2012_CapRateTable_Hotels_CapRates.pdf

Japan

While the Group’s activities in Japan are quite small in relation to their investments in Macau, Vietnam, and the U.S., they are the most recent transactions executed by the Group and offer further insight into the Group’s investment strategy. 

In early 2010, the Group purchased two freehold apartment buildings in Tokyo, Japan for a total consideration of HK$342m.  The properties were relatively new, built in 2005, and were located in Chuo-ku, one of the five central wards of Tokyo.  The Group acquired the buildings at an average cap rate of 6.4% at a time when average residential cap rates in Tokyo were reaching 10-year highs.  Domestic REITS and large U.S. institutions which had been very active on the buy side prior to 2008 had disappeared from the market, maximum loan-to-value ratios had dropped considerably to 60% and domestic financing was very difficult to attain, suggesting a bottom in the economic cycle at the time.  Two years later in September 2012, the Group was able to sell the two properties at a substantially improved average cap rate of 5.15%, generating a 19% unlevered IRR net of taxes.

The Group purchased the Best Western Hotel Fino Osaka Shinsaibashi for HK$177m in September 2011, at about a 6.5% cap rate.  Again, we think this looked like an attractive purchase near the bottom of the economic cycle.  In 2013, the weakened yen has driven a boom in tourism, which in turn has led to higher occupancy and room rates.  While this increase in revenue increase is offset somewhat by the weaker yen when translated back into Hong Kong dollars, it has resulted in slightly higher overall profitability.  It appears that cap rates have dropped about 0.5% across the board in Japan since the purchase, which would put the hotel’s current value at about HK$208m and the Group’s unlevered IRR above 10%.

While Japan is a very different market from Vietnam, San Francisco, or Macau, Keck Seng has still generated exceptional returns by investing in quality properties in good locations during market downturns at attractive yields.  We don’t expect to see further activity in Japan in the near future due to the market recovery underway. 

Total Japan Value: HK$208m

Sources:

http://www.nri-seoul.co.kr/opinion/2011_jp_realestate_en.pdf

http://www.nri.com/jp/opinion/r_report/pdf/japanreport2013_en_final.pdf

http://www.ibtimes.com/five-signs-japans-long-dead-real-estate-market-has-finally-come-back-life-1546719

http://www.keckseng.com.hk/Files/Announcement/2012/LTN20121025316.pdf

Other Assets – Singapore, China, Canada

The Group holds five residential flats from a development completed in Singapore in 1983.  We have used a local valuation tool to estimate the value of these properties, which can be found here:

http://www.propertyguru.com.sg/

We estimate that the flats are worth approximately HK$86m, and are held at what is likely a much lower development cost.  Given the fact that the Group sold the last of its flats in Hong Kong which it had held since the 1980s in 2009, we don’t count out the possibility that the Group may sell these flats in a booming Singapore market to raise more cash.

The Group has minority interests in several hotels in China and Canada.  We have simply valued the Group’s interests at book value, as we have limited data for a proper valuation.

Other Assets Total Valuation: HK$229m

Potential Uses of Cash Going Forward

Keck Seng management chooses not to talk to investors throughout the year to focus on running their business, and thus we have only been able to track them down at the Company’s AGM.  To effectively execute their investment strategy of picking up value where competition is limited, management is understandably mute about where else they are looking for deals.  We expect that the past is a good indicator of what will happen in the future, and they will continue to maintain a strong financial position that allows them to be opportunistic and make acquisitions at attractive valuations during market downturns.

We think the Group may be preparing to make a bid for some of the planned reclamation next to Ocean Gardens, although we expect that management would insist on an attractive rate of return.  There appears to be little risk that management may overbid for the land in order to protect the value of their current investments, as any potential new development would not block the sea views from the Group’s remaining flats.

Catalysts

If you’ve made it this far in the write-up, you probably know what we are going to say next.  We don’t think we need a catalyst or at this price even an improvement in valuation to do well over a long period of time.  As management continues to execute, growing FCF and underlying NAV should send the stock higher.  If management can continue to reinvest cash flow at double digit rates as they have in the past, the Company will grow larger and pop up on more and more screens, where it will stand out as too cheap to ignore.  It’s easy to find property investment companies listed in Hong Kong that trade at a deep discount to NAV, especially if the properties are located in Hong Kong where cap rates are 3%, but these companies will still typically trade at 10x recurring EBIT.  We think Keck Seng deserves to be valued at a similar multiple and can be a multi-bagger over the next five to ten years as the market recognizes the strength of their business.

Risks

The only legitimate risk we have identified is the risk of a management buyout on the cheap.  Our analysis strongly suggests that liquidation values are well in excess of carrying values on the balance sheet, and the stock is woefully underfollowed at the present time.  It’s possible that management could try to take the Company private without mentioning the hidden value and attractive prospects in Macau, U.S. and Vietnam.  However, takeover rules in Hong Kong enable minority shareholders to block a takeover proposal with only 10% of the minority shares, which in this case would be only 2.56% of the total shares outstanding.  We believe we have identified enough shares in the hands of sophisticated investors to avoid this risk.

There are several related party issues in Macau, including management’s minority shareholding in the Ocean Gardens property, related party loans to the Macau subsidiary, and the recent purchase of two Sakura Court flats by the Chairman.  However, there does not appear to be anything fishy or unfair about the transactions, nor does any management activity over the past decade make us doubt their character.  If anything, management’s actions have commanded our respect for their investment acumen, and our inquiries in Macau have led us to believe that they have a good reputation there.