CHKGF - CK Asset Holdings Looks Undervalued May Be Too Diversified To Appeal To Investors

2023-05-04 07:30:41 ET

Summary

• CK Asset Holdings is seeing some improvement in the Hong Kong residential property market, but the landbank here is still relatively small. China remains more challenging.
• The property rental business is exceptionally profitable, but weakness in the HK office and retail markets is a modest threat to the business.
• Roughly two-thirds of CK Asset's distributable income is now considered recurring, as management has reinvested more heavily into less-volatile businesses, including international utility distributors.
• CK Asset looks more than 20% undervalued today, but the business is a complicated mix of volatile and consistent operations that I believe will likely create a permanent discount to fair value.

There are a lot of ways to build a business, and often there is a tension (or at least a tradeoff) between building a business that investors, and especially institutional investors, will like and a business that could generate more consistent and stable cash flows and returns over the long term. While the latter sounds like a "Buffett type of business", these models can frustrate investors for long periods of time with relatively lackluster stock market performance.

This brings me to CK Asset Holdings ( OTCPK:CHKGF ) (1113.HK), a diversified Hong Kong conglomerate that has moved away from property development as its primary source of income and distributable earnings and toward a more balanced mix of slower-growing recurring revenue and earnings streams. While CK Asset looks better-placed now to generate more steady cash flows over time, and return more of that to shareholders, I worry that the mix of higher-risk property development, capital-intensive property investment, consumer-driven pub operations, and lower-risk infrastructure and utility assets creates a "neither fish nor fowl" mix of businesses that makes for a more challenging investment case.

I do believe that CK Asset shares are undervalued by around 20% to 30%, and I believe management has demonstrated good discipline and opportunism with its capital management decisions. Still, while I do see value here (and a less-risky business mix), investors considering this name should be prepared for a potentially long wait to realize that value.

Are Better Days Coming For Property Development And Management?

Last year (2022) was pretty miserable for Hong Kong residential property developers, as prices fell about 16% and primary volumes fell more than 40% due to the sharp increase in interest rates and economic pressures (and uncertainty) tied to pandemic lockdowns and border closures.

Since then, though, the economy has started to stabilize, rates in Hong Kong (as measured by HIBOR) have come down, and market sentiment has improved, with the Centa-Salesman Index (or CSI) recovering from a sub-30 reading in November of 2022 (consistent with market lows of part cycles) to almost 62 in February before settling back toward 55 recently.

This is generally positive for CK Asset, though it's worth remembering that management has been steadily reducing its exposure to Hong Kong residential property - the company had a landbank of over 15M sqft in 2008 before reducing that to around 4M at the low and now has around 7M to develop. The company also ended 2022 with about HKD 8B in unrecognized contract sales still left to flow into the income statement.

China is still more challenging, and CK Asset management said they're more bullish about the Hong Kong market than the Chinese market for the near term, as China continues to wrestle with lingering issues tied to the pandemic as well as significant issues in the property development sector (including local developers essentially bilking would-be homeowners out of their money). Here too, though, management has been backing away as part of a shift toward a more sustainable recurring business model - the mainland China landbank has shrunk from around 135M sqft in 2015 to 64M at the end of 2022.

All told, I believe the Hong Kong and Chinese residential property development markets (and CK Asset doesn't really do non-residential development) are on their way back. That's a positive for CK Asset on balance, but given management's decision to shift the business mix away from property development, the benefit to the company and its investors will be more muted than in past cycles.

Property Management Looks Mixed, With Better Hotel And Worse Office

CK Asset now generates about 25% of its attributable profit from various property management operations, including office and retail properties in Hong Kong (and a small portfolio in China), hotels and serviced suites (largely in Hong Kong), and other management functions (including REITs).

I'm not particularly bullish on the Hong Kong office or retail markets right now. While I do think the worst has been seen, there are still a lot of vacancies in the market, limiting rents, and I do see some risk that office and retail utilization may see long-term occupancy impacts from the pandemic.

At this point, I don't see these functions as growth drivers for CK Asset, and my belief is that management doesn't either - I don't expect further expansion of these portfolios, and I believe management would look to exit these properties and recycle the capital (into other income/cash-generating assets and/or returns to shareholders), but selling now would likely be leaving some money on the table and management can afford to be patient and let the market (and property values) recover.

Non-Property Businesses Are Stable-To-Improving, But Arguably Lack Flair

While CK Asset was initially established as a pure-play property developer and management company, that didn't last all that long and management has instead pursued a more typical investment conglomerate path. With that has come diversification into a range of businesses including UK pubs, utility companies, energy management, and appliance leasing.

These businesses generate respectable distributable cashflow and should do so on a fairly consistent basis provided we don't get another global pandemic (which hit the pub business hard), but they're heterogeneous and very different than the property development and management businesses. Gas and electricity distribution is generally a good business (companies like Brookfield Infrastructure ( BIP ) and Cosan ( CSAN ) have done well here), as is water, and likewise sub-metering (essentially helping rental property owners measure and allocate utility consumption/costs by unit) is a relatively consistent business.

The issue for me is how they mesh with the other businesses. The pub operations saw a strong rebound in FY'22 (revenue up 47%, profit reversing a year-ago loss to a 4% margin) on reopening, while the Infrastructure and Utility operations saw 10% revenue and 8% profit growth. Longer term, these are probably mid-to-high single-digit growth opportunities, and while that's a great offset to the boom-bust cycle of property development profits, more often than not investors in property development companies WANT that volatility (it's part of the model and they try to time investment entry/exit with the cycle).

So while the growing importance of these non-real estate operations do help neutralize the swings of property development and generate good distributable cash flow, I'm not sure typical property development investors want that counter-cyclical stabilization, while investors who typically value more stable businesses (like infrastructure/utility assets) likely won't like the volatility of the property development operations.

The Outlook

I expect a significant step down in FY'23 earnings as the company sold its aircraft leasing business and won't repeat the recognized gain on sale. While the property markets are improving, I still expect some year-over-year declines as the market sorts itself out, and I don't expect the pub or infrastructure/utility operations to grow enough to offset that.

Normalizing for one-time items and events, I expect long-term core distributable income growth of around 4%-5%, and with more income and cash flow coming from more stable recurring sources, I believe management will be more diligent about improving returns of capital to shareholders. With that, I expect payouts (dividends and buybacks) to exceed that growth rate.

There are many ways to try to value businesses like CK Asset, including core distributable earnings, a discount/premium to gross asset value, a multiple to book value, and a target dividend yield. I believe the first approach is the most rigorous, but it is absolutely true that forecasting the profits/profitability of property development more than a few years out is largely guesswork (including key questions like how much capital management will take from property sales to reinvest in land acquisition and development).

Based upon my long-term distributable income model, I think HKD 56 (or around $7/ADR) is a reasonable value target. My gross asset value and dividend yield approaches give me a somewhat higher range of HKD 60-65 (or $7.55 - $8.20/ADR).

The Bottom Line

I think CK Asset is undervalued and well run. Although I have found some of management's diversification choices curious or questionable at the time, they have largely worked out and I can't really object to the overall shift away from riskier/speculative, more volatile businesses in favor of businesses that generate more consistent distributable income. That said, as I've written in the past in reference to companies like CK Asset and CapitaLand , property development can be incredibly lucrative when done right, and businesses that mix highly volatile segments with more consistent businesses can often struggle to find a core investor base.

For investors who can be patient, I think there will be upside from this name over the years, but I do think patience is a key, and these shares may not appeal to all investors.

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