Swire Pacific Ltd SEHK:19
October 13, 2020 - 11:10am EST by
sediment
| 2020 | 2021 | ||||||
| Price: | 38.00 | EPS | 0 | 0 | |||
| Shares Out. (in M): | 1,501 | P/E | 0 | 0 | |||
| Market Cap (in $M): | 54,467 | P/FCF | 0 | 0 | |||
| Net Debt (in $M): | 77,259 | EBIT | 0 | 0 | |||
| TEV (in $M): | 164,641 | TEV/EBIT | 0 | 0 | |||
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Description
Swire Pacific Ltd (SEHK: 19) 太古集團, started as a family textile trading business by John Swire in 1816 in Liverpool, England, and grew to become an Asian (mainly Hong Kong & China) diversified conglomerate that is Hong Kong listed with a London & Hong Kong HQ. Swire Pacific is a family dynasty/clan spanning several generations, with businesses such as property (high quality office buildings and malls), HAECO (an aircraft maintenance service), and is a coke bottler for most provinces of China.
Despite these great businesses, Swire also has some problematic holdings which management should not even attempt to fix.
Core businesses include—
1. Coca Cola’s main bottler, distributor, and franchisee for China in 11 provinces, Hong Kong, Taiwan, and parts of California.
- As of June 2020, 63 beverage brands were distributed to 739 million people
- 67% of the total mix were sparkling drinks
2. 82% stake in 27M ft2 of property development:
- 14.4 mil ft2 in Hong Kong
- 9.7 mil ft2 in China (Shanghai, Beijing, Guang Zhou, Cheng Du)
- 2.7 mil ft2 in Singapore and Miami, Florida
3. A 45% ownership of an airline Cathay Pacific (236 aircrafts) and an aviation maintenance service called Haeco which repairs frames and engine parts, etc.
- Cathay just received a deal from the HK government to recapitalize its balance sheet
- Haeco, unlike Cathay, is healthy and just had an acquisition for an American company
Some peripheral, underperforming businesses include—
4. Sugar refining and sales, car dealerships, retail distribution through 191 retail outlets, waste management, and a faltering marine services group which owns 73 off shore support vessels serving the oil and gas industry.
5. Cold chain warehouses/storage and Akzo-Nobel paints which were recently disposed of.
There are too many businesses and management lacks the tenacity to dispose of sub-par businesses to focus on businesses where Swire has a chance of being the market leader.
Property is the largest contributor to underlying group profit, providing stable and predictable office and mall rental income to Swire Pacific.
Peripheral businesses contributes 15% to the topline and adversely affects the bottom line— especially the airline business, Cathay Pacific and the Marine Services business for oil and gas. This can serve as a drag to performance, but if resolved, or better yet, liquidated or spun off, may serve as a potential catalyst.
Why is it cheap?
The Covid-19 pandemic and previous protests in Hong Kong affected Swire’s luxury malls and office tenants who are largely from mainland China. For Swire Properties, the pandemic caused a HKD 2.6B(USD 333m) loss on revaluation of investment properties in the first six months of 2020, compared with a gain of HK 3.6B (USD460m) in 2019.
In aggregate, for the entire holdings for the first half of 2019, Swire had an underlying loss of HK 5.4B and a recurring underlying loss of HK132m.
In the first half of 2020, the underlying loss would be HK 1.04B and there would be a recurring underlying profit of HK 3.3B if the contributing results of Cathay Pacific were omitted.
Major impairments in the first half of 2020 were 16 aircrafts of Cathay Pacific at HKD 1B and certain subsidiaries, and vessels of Swire’s Marine division at HKD 4.3B.
Swire was once one of the largest constituents in the Hang Seng index (similar to S&P 500, but for Hong Kong listed stocks), but today, it is one of the smallest. Swire reported its first half-yearly loss in more than a decade at a net loss of HK 7.7billion (USD 1B).
A HK 9.9 billion net loss from Cathay Pacific, which Swire controls through a 45% stake, and a slump in demand for marine services were major contributors to poor results. The airline Cathay Pacific accounted for about 1/10th of Swire’s profits in 2019.
A third wave of covid-19 in Hong Kong and concerns about political instability also dampens travel to Hong Kong. Cathay Pacific expected a substantial loss in the first half of 2020 before a HKD 39 billion (HKD 5B) bailout from the Hong Kong government via bridge loans and preferential shares. For the first four months of 2020, Cathay reported an unaudited loss of HKD 4.5B and was burning through HKD 3B a month. After obtaining a source of funding required; air travel may recover, but to be conservative, cash flow generation may take 2-3 years.
Segment contribution to Revenue and Operating Earnings
Revenue Contribution for 2014, 2019, and Six months ended June 2020
A look at the top line masks the damage due to poor fuel pricing estimations with futures contract in 2017 for the airlines Cathay Pacific, and the social unrest in Hong Kong affecting office building rental fees from mainland Chinese and high end malls. However, the annual growth rate for coke and other trademarked beverages such as Gatorade, vitamin water, and localized bottled teas under coke in China, seem to be thriving with sustainable double digit year on year growth.
Operating Earnings Contribution for 2014, 2019, and Six months ended June 2020
From the chart above, you can tell that despite poor results above, if Swire had disposed of the Marine Services segment completely and had there been a full impairment earlier, the conglomerate would not have experienced losses in 2020. Bottling for coke has grown from a less than 10% contributor to EBIT to a nearly a fifth of total operating earnings.
A simple analysis operating profits, not the top line; gives you a better feel for this seemingly complex holding.
Impact of Pandemic (June 2019 – 2020)
Trading & Industrial and peripheral/sideline businesses may recover and will be cyclical. Most of retail trading, a partnership with Waste Management in Hong Kong, has been a blunder. The division that is propping up this segment is Swire’s car dealership for brands such as Volkswagen, Benz, Harley Davidson and Volvo in Taiwan and Hong Kong. Of the meager HKD 25m (USD 3.2B) in operating earnings, HKD99m came from Swire Motors, the other divisions had an underlying loss which pulled the aggregate down.
In bad times, property’s operating earnings almost contributes to the entire conglomerate’s (Swire Pacific) operating earnings. Should the pandemic improve and social unrest mitigate in Hong Kong, an improvement in the aviation, retail, and marine services could bring in an additional EBIT contribution, and serve as a catalyst for long term shareholders. However, for Cathay Pacific, management conservatively anticipates recovery in 2023 to a “normal” earnings experienced in the earlier part of the decade.
Currently sixth-generation descendant Merlin Swire assumed as chairman in 2018, and has been trying to fix things especially within Cathay Pacific. Hong Kong listed Cathay Pacific Airways Limited (SEHK: 293), has been undergoing a change since 2017 and had a reshuffle within the board of directors, which shows the Swire family’s disappointment with current performance.
The 3 questions concerning Swire’s future predicament are—
1. If Marine services/ Swire Pacific Offshore is so damaging to shareholders and value creation, why hasn’t Swire sold off its fleet of 72 vessels? Why haven’t they considered a spinoff in good times, or liquidate all assets and consider impairments on their statements?
Before Covid-19, Swire’s marine services segment has been facing falling oil prices and a shift to clean energy which saw revenue drop by 19% in 2019— thus continuing a declining trend since 2015. EBITDA also went negative in 2019.
In 2020, Swire Pacific Offshore continues with a recurring loss, with estimated impairment charges of HKD 4.3B (USD 500M), as demand for chartered hire for the oil and gas industry deteriorated significantly amid the pandemic. Exploration and production companies have cancelled or suspended existing projects and deferred future projects. As a result, there is an oversupply of vessels with day rates under pressure, with average daily chartered rates at USD 12,400, with specialist and construction vessels falling 56% to USD 25,600.
Swire’s charter hire revenue decreased by 22% to HKD920m (USD118.7m) for the first half of 2020. During the same period, SPO reported a loss of HKD4.97bn (USD642m), compared to a loss of HK633m(USD81.7m) in same period of 2019.
Swire Pacific Offshore SPO/marine services operates 72 offshore vessels that service the oil and gas industry and has been planning to sack 40% of fleet (4 to be sold and 28 to be stacked) as business conditions erode leading to HKD 4.3B in impairment charges. As of December 2019, Marine Services took up HKD 11.4B in assets; by June 2020, Swire had reduced it down to HKD 6.69B.
It is obvious chairman Merlin Swire is a bit delusional on this subject. Despite liquidating the fleet, in an earning’s call, he says that these assets are still valuable and he expects a recovery. Even if this were true, the fleets have poor business economics.
2. Cathay Pacific was in dire terms, bleeding HKD30 billion or USD 3.8B per month. After recapitalization via a HK govt. bail out, how does this affect future prospects?
In the first half of 2020, Cathay Pacific experienced its most challenging 6 months in its 70 year history with impairment charges of 2.5B for 16 aircrafts and other assets.
Passenger revenue declined due to travel restrictions which decreased revenue from passengers carried 76% to 4.3B, while the passenger load factor was 67%.
Despite passenger revenue declining, cargo revenue per AFTK increased 58% to $1.88 and Cargo yield increased 44% to USD 2.71 due to an imbalance between capacity and demand in the cargo market— capacity decreased, but demand did not substantially decrease.
To remain in China’s aviation market, Swire’s Cathay Pacific had to re-organize the carrier’s top management due to CCP’s discontent of Swire’s executive officers supporting social unrest in Hong Kong and a leak of private information of a policeman by cabin crew. This misconduct endangered a passenger’s life and inadequate response led to the departure of chief executive Rupert Hogg and Chairman John Slosar.
Recapitalization
The carrier reported a record HKD 9.9 billion (USD1.26B) interim loss, and has sought a bailout from the Hong Kong government to ride out the pandemic.
Cathay was close to bankruptcy if they had not secured funding— “The reality is that the recapitalization plan announced is the only plan available to Cathay Pacific, the alternative would have been a collapse of the company” said Patrick Healy, Cathay’s chairman.
As of June 2020, Cathay Pacific has a debt to equity of 203% and an EBITDA to interest expense of 2.7x. In contrast, 5 years ago in 2015, Cathay only had a debt to equity of 131%, with EBITDA to an interest expense of 14.2x.
By June 2020, Cathay announced a HKD 39B recapitalization, comprising of HKD 19.5B preference shares, HKD 11.7B in rights issue, and HKD 7.8B in a bridging loan facility. Cathay will initially pay the Hong Kong government a 3% annual dividend on its HK$19.5bn worth of preferential shares. Hong Kong’s financial secretary, Paul Chan, said that the government did not plan to be a long-term shareholder in the company. The recapitalization was completed in August 2020.
Despite the Hong Kong government offering a bail out, long term solvency for Cathay is still in question due to the virus hampering passenger travel.
The misnomer of CCP interfering--
When Cathay Pacific’s 2 largest shareholders, Swire (45%), and China National Aviation (27%) briefly suspended trading shares, the speculation was that Beijing-backed Air China was about to finally replace Swire Pacific as Cathay’s majority shareholder.
This is a misnomer and business economics should improve. The rights issue will leave Swire and Air China with slightly reduced stakes of 42% and 28% respectively.
State Owned (CCP) Air China had enough of its own problems and did not want additional trouble from Cathay. Air China also faces its own financial challenges, having booked a net loss of Rmb4.8bn (USD680m) in the first quarter of 2020.
Hong Kong citizens are big travelers. When another infectious respiratory virus, SARS, hit in 2003; within 3 months of the peak, Hong Kong travelers were back in plane, bars, and restaurant. After the pandemic flight bookings will quickly resume.
The Airline’s Business Economics
Cost per available ton per kilometer, inclusive of fuel, was HKD 3.12 in 2019, and HKD 3.75 in 2020, while available ton kilometers (ATK) shrunk from 16.3B to 8.5B, causing revenue ton kilometers (RTK) to shrink from 11.9B in 2019 to 5.9B in 2020.
Cargo revenue actually went up 9% due to an imbalance between capacity and demand despite Cathay’s capacity decreasing by 31% with half the cargo going into the belly of passenger aircrafts and utilization of 2,228 pairs of cargo online flights operated.
The 76% drop in the first half of 2020 to 4.4 million passengers, in addition to a 66% decrease in passenger capacity compared to 2019 made RPK drop from HKD68B in 2019 to HKD18.6 in 2020.
The average depreciation of a plane, depending on the model and maintenance, is around 15-25 years. The average age of Cathay’s fleet is around 10 to 11 years. The 224 fleet owned by HK Express, Cathay Pacific, and Cathay Dragon still has some time before purchase; however, impairment charges of hkd
2.46B relating to 16 aircrafts were unlikely to re-enter in meaningful service before they are returned to lessors or retired.
3. What are Swire’s business economics for quality core businesses— high end office building rental and malls, Haeco, and Coke bottling? What is the return on equity and will this improve?
ROE and Assets/ What does book value comprise of? What are the business economics of core and contributing segments?
Capital employed = working capital (C.A- C.L = 45-32B) + fixed assets/PPE + property valuation = 13B + 40B + 300B = 353B. Capital returned is 7-13B. In order for ROIC to reach 10%, 35-40B or more of EBIT has to be achieved and without property revaluation and non-recurring profits factored in. With Swire’s sedentary mindset, and despite covid-19 being a great opportunity to completely abandon certain industries, it seems that Swire won’t take drastic measures to ensure great returns.
On average, Swire Pacific has a return on equity of 2-3% with Property, Aviation (Haeco maintenance services & Cathay Pacific), and Coca-Cola’s distribution as the main contributors.
Taikoo Sugar, Swire’s retail division, Marine and Cargo Services, are all a distraction and eating up money and human resources— it should be considered for a spin-off, and even if these business do well, it doesn’t have the scale to move the needle.
Without these businesses, capital employed would be HKD 5 to 20B less, but this wouldn’t really reduce capital employed, as the property division will always employ more than 300B of capital and is levered, while capital returned will not increase that dramatically. At least 30B of free cash flow is required to get
ROE to double digits. As of the last decade, operating earnings has been 8-12B HKD. I don’t expect such a drastic increase anytime soon.
There was a “restructuring” in 2017, but did not show too much promise. Until Swire properly disposes of these units, they are wasting shareholder’s capital. Swire invested in cold storage and Azko-Nobel paints over many years only to sell it, this shows poor capital allocation skills. One wonders if their 15%
investment in 2020 into healthcare to diversify into a new field the YangZhe river region of China may be “di-worsification” after all.
Coca Cola Bottling
Disregarding a withholding tax payment in the USA from 2019, the profit of Swire Coca Cola has increased 14%. While Coca-Cola saw its revenue reduced by the coronavirus during Q2, China provided a bright spot.
CEO James Quincey noted during the Q2 earnings call, "In China, we placed a big emphasis on our sparkling portfolio during the height of the lockdown," continuing, "as a result, the category grew 14% in volume this quarter, led by trademark Coke with strong growth in Zero Sugar offerings."
Responding to positive Q2 sales figures in China, Swire Coca-Cola plans to open 6 or more facilities before the end of 2020. This new capacity should be operational in 2020, but may be delayed to 2021 due to the Covid-19.
The new bottling capacity will cost approximately 36 million to complete, while the facilities are expected to crank out 244 million worth of soda and other soft drinks per year. This capacity will be well received as in China alone, Coke has doubled in sales volume in the last decade (2009 to 2019).
Swire Coca-Cola has an annual sales volume of 1.7B cases contributing to 43B of revenue, 26 bottling plants serve over 730 million people (of which 674m are in China, see graph below) which includes most of China (11 provinces) and of the 26 bottling plants— of which 5 plants are in the West coast (Colorado, Utah, Arizona, Idaho, Washington)
On another note, besides Swire, another of Coca-Cola's bottling partners in China, COFCO, is building a large facility in southern China, expected to produce around 187,000 tons of beverages annually. This facility is not expected to open sometime late next year.
COFCO and Swire are the two only franchises and bottlers operating in China. On February 2016, Coke Co. announced a non-binding letter of intent to negotiate the refranchising of its bottling operations with existing partners, COFCO and Swire. This was complete, and at the time, COFCO was operating 18 bottling plants, and Swire operated 17 plants in Mainland China. In 4 years, 6 plants were added and demand has always caught up to new capacity.
HAECO: Aviation frame and engine Maintenance
Another high quality business of Swire’s is Hong Kong Aircraft Engineering Company Limited (“HAECO Group”) which repairs and services the engines and frames of the aircraft of over 300 airlines. HAECO, is extremely dependent on wide-body business rather than narrow-body business, and international wide-body travel will recover more slowly than narrow bodies, which tend to operate within domestic markets.
Aircraft maintenance brings in cash flow at a similar Cathay Pacific, with much lower capital requirements. HAECO Hong Kong saw a big reduction in profitability driven primarily by the line services business in Hong Kong where there was dramatically reduced demand.
HAECO Americas, which has been losing money for a number of years, reported a profit in the first half due to financial support from the U.S. government. HAECO has recently strategically acquired Jet Engine Solutions, LLC (“JES”), an engine MRO based in Dallas, Texas, which specializes in quick-turn repairs and lease returns for commercial aircraft engines. This should hopefully bring better prospects to U.S operations.
HAECO Xiamen and TEXL, which is Swire’s General Electric engine shop in Xiamen, are both down— reflecting customers deferring maintenance to conserve capital. But HAESL in Hong Kong, which Swire’s Rolls-Royce engine joint venture, has continued to show growth. Xiamen is a big contributor to HAECO,
and Swire will be relocating their operations to the new airport in Xiamen.
When we look deeper into total recurring profits, which was HKD555M, Haeco Xiamen contributed HKD
111M, while HAESL contributed to 247M due to the global backlog of engine repair work. When you
have a big reduction in commercial airline operations, there is a lag effect before maintenance starts to
slow up.
Property Development
Most of underlying earnings derives from office building rentals in Hong Kong and China from Chinese companies and rental from luxury conglomerates and brands in malls. Hotels and residential development only takes up a small portion