CNGKY - CK Asset Holdings Weathering Multiple Headwinds In Hong Kong

2023-10-10 23:23:43 ET

Summary

• Hong Kong property developers have been hit by higher rates, weak property markets, and softening conditions in China, but CK Asset has held up better than most.
• The company's focus on growing recurring revenue and profits, as well as increased travel and shopping in Hong Kong, have provided some stability.
• The current environment for properties could be an opportunity for CK Asset to replenish its land bank, but the company's diverse operations make it a challenging investment for most investors.
• CK Asset shares look undervalued today, but HK property developers as a group haven't generated great long-term returns and the risks here are above-average.

With higher interest rates, weak pricing for rental properties, and growing concerns about the health of mainland China, "less bad" is about as good as it gets with Hong Kong property developers these days. In that limited context, CK Asset Holdings ' (CHKGF) (1113.HK) performance since my last update has been better than most but hardly good, with a 11% decline versus the 20% to 30%-plus declines seen at peers like Hongkong Land Holdings (HKHGF), Sun Hung Kai (SUHJF), Henderson Land (HLDCY), and Hysan (HYSNY), and with only a few outliers like Wharf (WARFF) doing meaningfully better.

There are still positives in play here - the company's focus on growing recurring revenue and profits has lent more stability to operations, the property development business is still quite profitable, and the company is benefiting from increased travel and shopping in Hong Kong. Moreover, the company has gotten better with capital returns to shareholders, including spending HK$1.4B on buybacks in the first half of the year, and the current depressed environment for properties could be an opportunity to replenish the property development land bank.

Still, this is not an easy investment to follow, model, or benchmark for most investors. There are a lot of moving parts and "quirks" associated with real estate/property development accounting, and this sector has a reputation for management teams more interested in their long-term success than that of shareholders. I don't think that applies as much to CK Asset, but I do note that the company's diverse operations are likely an impediment for investors who want the boom/bust nature of property development, and while the shares look meaningfully undervalued, this is not an easy stock to recommend to most investors.

Higher Rates, Weaker Rents, And A Weaker Mainland - None Of This Is Good For CK Asset

As things stand today, there are only a limited number of drivers I'd consider positive for HK property developers, and quite a few more drivers that I'd call headwinds.

Higher rates have not helped the situation, as the one-month HIBOR rate has jumped from 4.2% to over 5% at one point before settling toward 4.8% more recently. As property companies usually move in the opposite direction of rates, this clearly hasn't helped and it seems optimistic to expect any significant rate relief in the near term as countries like the U.S. continue to battle inflation.

Weak rents also remain an issue. Office rents have been trending down around 3% to 4% for much of the year and now stand more than 30% below the pre-pandemic peak. While desirable properties (up-to-date buildings in attractive areas) are faring better, and CK Asset's portfolio skews above average, it still makes for a challenging environment and CK Asset reported a 15% year-over-year decline in office rental revenue in the first half of the year. Other categories are better, but not by much. Retail rents have been basically flat, and while residential has continued to recover, prices are only up about 5% and still well off prior highs.

Last but not least, deteriorating economic conditions in mainland China remain a threat. A lot of business in Hong Kong is driven by China, and in the case of CK Asset there is some exposure to hotel and retail. Retail has been good this year as shoppers have come back following the removal of pandemic restrictions, but even here the 20%-plus growth seen in the first half of the year has slowed to mid-teens (up 13.7%) growth in August; Hysan and Wharf have more exposure here. Likewise, while hotel occupancy was considerably better for CK Asset in the first half (75% vs. 58%), prolonged weakness in China's economy won't be helpful for the hotel exposure enjoyed by companies like CK Asset, Kerry (KRYPF), and Sino Land (SNLAY).

Never Waste A Crisis - Is A Weak Market An Opportunity?

It's hyperbole to call the current state of the Hong Kong property market a "crisis", but it is definitely under stress. CK Asset doesn't have a lot of development coming through the pipeline that they'll have to sell into a depressed market, and development margins are still good (over 38% property sale margins in Hong Kong in 1H'23 and 47% margin for China), but this is a challenged market and the company has seen a previously agreed-upon sale (21 Borrett Road) fall through.

The flip side to all of this is that this could be a buyer's market for companies like CK Asset willing and able to put capital to work in growing their land bank. Just how committed to this idea CK Asset management is remains an open question; management has been cautious in their commentary and I wouldn't really expect them to flag a strong interest in buying properties (why effectively bid against yourself?). Still, as high-quality office properties are still getting decent rents and there could be opportunities to redevelop or repurpose older, lower-grade properties, I wouldn't be shocked if CK Asset pivots more toward land acquisition even as the company continues to build up its less volatile businesses.

On that subject, I'd note that the pub business is seeing so-so performance, with revenue up 7% and profits down 32% in the first half, as the company is seeing a significant hit from cost inflation. The infrastructure and utility businesses likewise saw some cost inflation impacts, with revenue flat and profits down 3%, but with strong (34%) profit margins.

I also want to note an acquisition made earlier this year - the HK$4.8B acquisition of the UK's Civitas Social Housing. This business owns a portfolio of social housing properties in the UK, and while capped rents (about one-third capped at 4% or less and the rest at CPI or CPI plus 100bp) do limit the upside, vacancy isn't really an issue here and the properties are not all that expensive to operate. At a minimum, it seems consistent with management's track record of embracing more stable cash flow-generating businesses over more boom/bust speculative businesses.

The Outlook

Whether or not CK Asset makes a significant move to replenish its land bank is a key modeling unknown. Even if the company were to do this, though, I don't think it would represent a major shift in strategy, but rather just an opportunistic move to take advantage of attractive development opportunities from a company with a strong property development track record.

As is, I'm now expecting core earnings to decline about one-third this year (my '23 estimate is about 3% lower than it was at the time of my last update) before rebounding in 2024 and 2025. I'm looking for around 1% core growth from 2022 to 2027 and long-term core growth in the 2% to 3% range. Those earnings should support healthy cash flows, but it remains to be seen how management will allocate that between returns to shareholders and reinvesting in the business - stingy returns to shareholders have been a complaint in the past.

Between discounted core earnings and a NAV-based approach, I think CK Asset is about 30% to 40% undervalued today. Each of these valuation approaches has its issues - core earnings can be significantly impacted by large property sales and NAV can often become little more than an exercise in substituting accuracy for precision (making numerous small estimates or guesses).

The Bottom Line

It's tough to be all that bullish on a HK property developer when rates are high, office space demand is soft, and conditions in mainland China could still worsen further. Moreover, this isn't a sector that has done much for shareholders over the last decade in terms of total return. I do think that CK Asset is better than most and has some company-specific drivers that push it toward the top of the list, not to mention an attractive valuation, but I can't argue that this is a must-invest sector or company for investors.

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