|Shares Out. (in M):||489||P/E||0.0x||0.0x|
|Market Cap (in $M):||1,002||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||0||EBIT||0||0|
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Through Shun Ho Technology (“SHT”) you can own 6 hotels and 2 commercial buildings in Hong Kong and 1 hotel in Shanghai at 11.6% of current market value and implied cap rates of 24%, with long-term value-oriented management and no net-debt. You can express this idea through SHT with a free float of US$ 47M and its listed parent company Shun Ho Resources (“SHR”) with a free float of US$ 24M.
ALL FIGURES IN HK$: Shun Ho Technology Holdings Ltd (219:HK) is a Hong Kong based, Hong Kong listed, company active in property investment & development and which overtime transformed itself into a portfolio of cash flow generating properties.
The company is part of a holding structure described below. Through this holding structure, SHT owns 5 hotels in HK operating under the Ramada and Best Western brands, 1 HK hotel under development, and 2 large commercial buildings.
The company also owns the Magnificent Intl Hotel in Shanghai.
All these assets are held in Magnificent Estates Ltd (“MAG” – ticker 201:HK). SHT owns a 71.09% stake in MAG.
In our opinion, MAG is now at an inflection point, as it transformed itself from a property developer into a cash flow generating investment company.
By the end of the year the last hotel in the development pipeline is expected to be operational. Without further planned capex, the company will only increase its already substantial cash flow generation. William Cheng Kai Man, Chairman and CEO, made the following statement in the 2013 annual report: “2014 and onwards will be the HARVESTING YEARS for MAG, after many years of development of the new hotels”.
An 88.4% discount to current market value and 26% free cash-flow yield makes that SHT’s valuation more than compensates for the high property prices in HK as well as potential corporate governance concerns (but of which we have found none justifying anywhere near this massive discount).
COMPLEX HOLDING STRUCTURE:
W. Cheng, through his private company Trillion Resources Ltd, owns a 50.6% stake in Shun Ho Resources Holdings Ltd (253:HK). SHR’s only asset is a 54.26% stake in SHT. SHT has a 71.09% stake in MAG. MAG owns 12.69% of SHT and 20.57% of SHR. The simplified diagram below illustrates holdings and cross-holdings. Whilst the practice of cross-holdings used to be en vogue in a distant past, they are no longer allowed by Law and W. Cheng’s structure was grandfathered in the process.
The company, which had traditionally invested in office buildings and residential properties, saw an opportunity to focus on hotel development in 2004. W. Cheng said at the time that the company found it difficult to make a profit in residential development after land costs had surged.
MAG purchased old buildings and run-down shopping malls, with a plan to convert them to 3~4-star hotels in anticipation of strong growth in tourism, especially from Mainland China. Today, the average room rate of HK$ 679 to HK$ 1032 per night in the hotels represent this tourist budget.
The CORPORATE STRATEGY of the Group is to build hotels on grade-B commercial locations most suitable for hotel business in terms of low acquisition costs and high returns. The Group presently owns and operates six hotels including: 1) Ramada Hotel Kowloon, 2) Ramada Hong Kong Hotel, 3) Best Western Hotel Causeway Bay, 4) Best Western Hotel Harbour View, 5) Best Western Grand Hotel and, 6) Magnificent International Hotel, Shanghai. All together 1,823 rooms. With the new Grand City Hotel at Queen’s Road West in final phase of development, the Group will have a total of 2,037 rooms and will be one of the largest hotel groups in Hong Kong.
With the last project in the development pipeline to be completed by the end of the year, MAG has over time developed into a portfolio of income generating properties in HK. A hotel based in Macau was sold earlier this year and the hotel in Shanghai represents just 3% of assets. MAG generates approx. 85% of its revenues from hotels, the balance from letting 2 office buildings and some retail shops (think ground floors of buildings & hotels).
MAG owns a 100% interest in the 7 hotels and 2 commercial properties with a book value of HK$ 5.8B and an estimated market value of HK 11.7B (DTZ valuation December 2013). The company also has HK$ 1.1B in cash.
The hotels are in the books at cost less depreciation (HK$ 2.6B), an amount substantially below the estimated market value by DTZ (HK$ 9.0B). The office properties are on the balance sheet at a market value of HK$ 2.7B.
In 2014 MAG completed the sale of the Best Western Macau for HK$ 900M, which generated HK$ 40M EBITDA in 2013. The disposal resulted in a profit of approx. HK$ 620M in the 1st half of 2014.
MAG currently owns 5 hotels in HK managed for Best Western (3) and Ramada (2) and one hotel under development. 3 hotels are located in the Western District, 2 in Kowloon and 1 in Causeway Bay. Favorable supply/demand dynamics have resulted in growing RevPAR, consistent high occupancy rates (>95%) and low cap rates (DTZ valuation indicates cap rates between 3.7% and 4.3%).
The 3 and 4-star hotels are targeted to benefit from the increase in tourism in HK. Hong Kong's market for overnight-stay inbound tourism has been increasing at a compound annual growth rate of 9% since 2000. A relaxation of travel restrictions for Mainland Chinese has been a major driver behind the strong growth (a trend we do not see changing in the future, see below).
With average room rates between HK$ 679 and HK$ 1032, the hotels are well positioned to continue to benefit from this trend as demonstrated by the continuously high occupancy rates.
HK Hotel demand: with further relaxation of travel restrictions for Mainland Chinese and the increase in purchasing power, the growth in travel is well supported. The government forecasts that total visitor arrivals could exceed 70 million by 2017 and 100 million by 2023 (2013 was 52 million of which 38 million were Mainland Chinese).
HK Hotel supply: Over the past five years, the supply of hotels has grown 29% while overnight-stay visitor arrivals have increased 48%. This shortage in supply in combination with the forecasted strong growth in demand is likely to motivate investors and developers to invest in new hotels. The Government has undertaken a number of initiatives since 2008 to promote hotel development to meet the diversified needs of HK visitors. For example, since 2008 a number of sites in different parts of Hong Kong have been designated “hotel only” sites. There are also initiatives to allow conversion of old industrial buildings and re-vitalization of heritage buildings into hotels.
However, the current cost of land makes new development in the downtown area difficult to come by.
Cushman & Wakefield expects the number of hotel rooms to increase by 2.3% p.a. from 2013 to 2017. The HK Tourist Board’s forecast for annual growth in hotel room supply for the next 5 years is 2.0%.
MAG also owns a hotel in Shanghai with an estimated market value of HK$ 390M. This asset represents only 3% of assets.
b) Investment Properties:
The grade-A office property, 633 King’s Road, is fully occupied and generated HK$ 73M in rental income in 2013. DTZ valued the property at HK$ 2.16B or a cap rate of 3.4%. In the latest interim statement the company stated that most of the leases were up for renewal in 2014 resulting in rent increases to HK$ 90M as at the date of the announcement. Applying the run rate rent to the 2013 valuation, the cap rate increases to 4.2%, which implies further property price appreciation for this property.
The Shun Ho Tower, 24-30 Ice House Street, Central HK, is also fully occupied and generated HK$ 19.5M in rental income in 2013. DTZ valued the property at HK$ 569M or a 3.4% cap rate.
The retail shops are located in the company’s hotels and are part of the DTZ valuation of these hotels. On the balance sheet the retail shops are part of investment properties, but the hotels are under PP&E.
MAG’s book value is HK$ 6.0B and the net asset value is HK$ 10.65B based on DTZ’s valuation without taking into account its stakes in SHT and SHR (MAG owns 12.69% of SHT and 20.57% of SHR).
SHT owns 71.09% of MAG worth HK$ 7.57B at market prices. Its indirect stake in SHR adds HK$ 689M. SHT also owns land that it purchased more than 10 years ago, booked at cost less depreciation. It also owns an advance to MAG for HK$ 105M. Net of a small SHT-specific liability, this brings the NAV to HK$ 8.62B. At the current stock price of HK$ 2.05, SHT’s market cap is HK$ 1B (adjusted for its stake in the shares of SHT held by MAG) or an 88.4% discount to NAV.
What are we paying for the underlying assets if we apply this discount to the assets?
We get 6 hotels in HK with 1824 rooms at an average price of HK$ 545M/Room (US$ 70,851). The 5 operational hotels in HK generated HK$ 318M in EBITDA in 2013. Through SHT we pay HK$ 1B for these hotels and get HK$ 226M in EBITDA, or an implied cap rate of 24.2%!!!
We also get 29,153 m2 of commercial buildings worth HK$ 93,643 / m2 for HK$ 10,860 / m2 ($1,412) through the discount. The implied valuation is HK$ 317M for HK$ 78.2M in annual rent, or a 24.7% rental yield.
Although we have serious concerns about property prices in HK we believe that the price we pay for SHT offers a lot of downside protection and the potential for an attractive return through office rental income and hotel free cash flow generation, all with the added optionality from a narrowing discount to NAV.
W. Cheng is both Chairman and CEO (for the last 25 years) and controls SHT and MAG through his 50.6% stake in Shun Ho Resources. SHR owns 59.64% of SHT. MAG, SHT and SHR are all listed on the HK stock exchange.
W. Cheng is the sun-in-law of HK tycoon Lee Shau-kee, majority owner of Henderson Land Development and number 27 in the Forbes rich list with an estimated net worth of US$ 22B.
In 1990, W. Cheng’s reputation got damaged due to an investigation by the regulator claiming that he unlawfully bought shares by using befriended nominees to increase his stake in SHR above 35% without launching a mandatory general offer. We have found nothing untoward since that incident, and on the positive side, the above events date from 25 years ago and a lot has changed since then.
Today, Mr. Cheng is managing these companies as his personal investment vehicles and we do run the risk that the rights of minority shareholders are not respected. This is a negative point in our investment case.
W. Cheng has been successful in growing the intrinsic value of the companies at an attractive rate. See capital allocation below.
Management compensation is reasonable. During 2013 W. Cheng’s total look-through compensation was HK$ 9M of which HK$ 3.6M fixed and HK$ 5.4M performance related bonus payments.
MAG’s focus has been on the development of the properties as described above. The company’s share count has increased with 63.7% since 2006. In 2007 MAG issued shares and a mandatory convertible to fund capex during the global financial crisis
Over the last 7.5 years BV/share compounded at 14.8% and BV at market/share at 26.7%.
Historically MAG has paid a dividend equal to approx. 1% of the Company’s market cap before the date of the results announcement. In 2013 this dividend increased to 2% of the market cap.
SHT’s only source of cash flow is the dividend it receives from MAG and rent from land it leases to MAG. Historically SHT has lend its available cash back to MAG. In 2007 SHT sold part of its stake in MAG for HK$ 180M into the open market, and its advance to MAG grew to HK$ 530M. In 2008, this advance declined again to HK$ 45M as SHT’s stake in MAG increased and SHT subscribed the entire MAG mandatory convertible issue. This share purchase and the conversion of the convertible in 2011 brought SHT’s stake in MAG to the current level of 71.09%.
Over the last 7.5 years SHT’s BV/share compounded at 17.8% and BV at market/share at 28.5%.
We’re less enthusiastic about SHT purchase in 2013 of a 25% stake in Trans-Profit (what’s in a name), a subsidiary of MAG. SHT paid HK$ 113M and its share in NI was HK$ 2.34M. The company has not disclosed further details on Trans-profit and these types of transactions are detrimental to transparency.
Furthermore, SHT has a history of not paying a dividend.
In the past, visibility on capital allocation was high because it was required to develop the projects in the pipeline. Today, visibility on future capital allocation is low, primarily due to the changed nature of the business activity.
When considering new investments W. Cheng targets an annual operating return >10% on development cost and a real estate capital gain potential of 50%. W. Cheng has shown discipline in capital allocation when investment opportunities at attractive prices are not available.
Communication with management is difficult, but not impossible. In a recent e-mail exchange William Cheng expressed his view that property prices in HK are too expensive, evidenced by the fact that no new investments have been made for a while.
A change in the capital allocation strategy seems likely unless HK property prices decline substantially.
As the company enters its harvesting years, it has the opportunity to take capital allocation decisions that can have a disproportionate positive impact on the share price (such as a further increase in the dividend by MAG, the introduction of a dividend at SHT and SHR, share buy backs and a simplification of the holding structure).
The company’s track record of growing its intrinsic value and the CEO’s large personal stake give us comfort that the company will be managed to grow shareholder value over the long term.
Liquidity: small free float
No analyst coverage
Communication: - the companies are not promoted to the investment community,
- W. Cheng is a hard to meet man and communication has been electronic
Corporate Structure: cascade structure to leverage control by W. Cheng with cross holdings
Corporate governance: see comments above
Dividend policy: SHT and SHR have a history of not paying dividends
Market sentiment: negative market sentiment around economic growth in China and Chinese real estate in particular, sentiment of overvaluation in HK real estate.
We believe that buying property at an 88.4% discount and a 26% FCF Yield reduces the property risk considerably. If HK property prices drop 50% we still own it at a 76% discount and if the current level of FCF is maintained for 4 years, a likely scenario, the company will own cash equal to the current market cap.
Several developments are likely to increase the intrinsic value and NAV will compound at an attractive rate from the current FCF.
Poor capital allocation is a risk and visibility is low with regards to how the company will use cash-flows and the substantial buying power that goes with a debt free, real estate heavy balance sheet. The company’s track record about growing its intrinsic value and the CEO’s large personal stake give us confidence that the company will be managed to grow shareholder value over the long term. It’s possible that management could try to take the Company private on the cheap. 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 3.3% (for SHT this equals to just $5M and for SHR this equals to just $2.5M) of the total shares outstanding.
Note: the investment thesis also applies to SHR. For the purpose of this write-up we have focused on SHT because of slightly better liquidity and a modestly cheaper valuation. We are long both SHR & SHT.
1/ ‘Time to harvest’
The company has transformed from a property developer to an investment company with cash flow producing properties.
2/ Recent market developments: confirm the trend of the last 5 to 10 years with visitor arrivals YTD+12%, hotel room occupancy rates at 90% (up from 88%), expenditure from overnight visitors +12.2% and hotel room supply +4.8%
3/ Recent results (1H2014)
Good performance from the company’s hotels: occupancy rates are maintained at high levels (97% ~ 99%) and RevPar increased resulting in a +4% increase for hotel revenues.
Rental income from investment properties is also increasing (+12%) and the company expected further increases in 2H2014 as more leases will come up for renewal.
4/ (Special) Dividend
With the conversion from a development company into a portfolio of income producing real estate and with W. Cheng not seeing any attractive investment opportunities the payment of a (special) dividend might be an option. However, this might not be in his personal interest (might consider SHT as a personal investment vehicle) and the possibility was not yet mentioned in any of the listed companies communications.
5/ Share Buy-backs
HK rules require a minimum free float of 25%. With free floats of 28.91% at MAG; 33.06% at SHT and 28.8% at SHR, there’s limited potential for these companies to buy back shares. In March of this year SHR purchased 9.5M SHT shares (1.77% of outstanding shares), the first such trade since 2001.
6/ Simplification of the holding structure
The small free-float, the low valuation of the shares, the FCF generation and borrowing capacity at MAG, the high market price for empty clean HK-listed shell companies (we understand from several sources this to be HK$500M) and the lack of investment opportunities are all contributing to the opportunity for the simplification of the corporate structure. W. Cheng can offer minority shareholders a large premium to the current share price and the transaction would still be highly profitable for him.
7/ MTR Western Line
Management comment in AR2013:
‘The management is most excited with the connection of the MTR Western line in 2014, which will significantly
benefit our three hotels with about 1,000 rooms in terms of occupancies, room rates and hotel values.’
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