Thursday, October 13, 2016

Shui On Land (272 HK) has still not started working for the shareholders.

No cause for celebration for the shareholders

This year, Shui On Land (stock code: 272.HK) will finish 10 years as a listed company on the stock exchange in Hong Kong and instead of celebrating, its shareholders (until recently, we were one of them) will be in mourning.

Since listing in late 2006, Shui On Land has lost 48% in value (total return - including dividends), producing an annualized return of -6%. Over the same timeframe, Hang Seng Index has generated a Positive return of 75%, or 5.8% annualized. In other words, if you had invested in Shui On Land at its IPO in 2006, your HK$100 invested would have been worth only HK$55. The same amount, invested in Hang Seng Index ETF, would have been worth HK$183.

If you were a fund manager with such a track record, underperforming your index by over 11% annually, you would have got fired long time ago, and your fund would have gone into extinction as investors would have pulled out all their money.

How has the company managed such an extraordinary feat?

World-class projects do not translate to shareholder returns

Shui On Land is a great name in property development, being credited with perhaps the most famous urban redevelopment project globally, Shanghai Xintiandi. In 1997, the company negotiated an urban redevelopment scheme in the Taipingqiao area of Shanghai. In the deal, Shui On took the responsibility of redeveloping an area covering 30,000 sqm of land, committing an investment of US$3bn over a fifteen year period. The construction displaced 3,500 households. The area was redeveloped into a cultural, retail, entertainment and commercial hub, in a mix of low and high-rise development. Most of the features of the old "Shikumen" architecture were retained, and so were some historical landmarks. The project was a huge success, winning global accolades and resulting in significant property price appreciation in the project and for the surrounding areas. It lifted company's profile and following the success of Xintiandi, Shui On received many such redevelopment projects across the country.  

However, Shui On's model of 'integrated' development resulted in projects with long gestation period that are heavy in upfront capex, with returns that accrue only at the tail end of the development cycle. Majority of the projects involve years of resettlement and rehabilitation of existing residents, for which the compensation has to be paid upfront.

Over the years, Shui On has amassed an investment property portfolio valued at RMB56bn (inclusive of RMB12bn of investment properties under development). Over 80% of the rental income is derived from high quality assets in Shanghai. Annualized gross rental yield (calculated using the actual gross rental income in 1H16) based on the current market value of investment property is only 3.9%.

Working for the bondholders

A combination of above factors has caused Shui On's RoE to steadily decline from a peak of 16.5% in 2007 to just over 2% in 2015. Longer gestation on its construction projects, and a reluctance to monetize fully valued investment portfolio has kept Shui On's  asset turn consistently low. All this resulted in very high debt burden on the company. Company's debt peaked in 2015 at RMB48bn, with a net gearing of 81%. More than a third of this debt is through USD denominated bonds, on which Shui On pays on average 9%+ coupon. Shui On's average cost on its debt is >6%.

We saw this and concluded that Shui On Land's management was working for its lenders and bondholders: it pays over 6% average in  interest, while on an investment property portfolio of even bigger value, it takes home only 3.9% in gross rentals (net of maintenance and management costs, this would be even lower). And indeed, our association with Shui On started with its bonds, in 2013 when its 10.125% coupon perpetual bonds started trading below par. With the company's background as a successful reputed developer and quality of its investment property portfolio, we got comfortable that company is unlikely to default: even in a situation of complete distress, it could easily unlock significant value by selling its investment properties.

As a holder in Shui On's bonds, we used to meet its Investor Relations personnel and attended the analyst briefings after each results. However, our conclusion remained that the company was working for its bondholders and not shareholders, and we paid scant attention to its stock.

The Chairman, Mr. Lo, intervenes

That changed towards end-2014. In early 2015, Mr. Vincent Lo, the controlling shareholder of Shui On Land who owns 57% of Shui On's shares, started looking at the operations of the company on active basis. During an analyst briefing we attended for its 2014 results, Mr. Lo was forceful in articulating its strategy. Its multi-pronged plan was to start selling low-yielding assets, stay away from long gestation projects requiring a lot of upfront capex; instead, look for JVs with local partners. The strategy called for increasing the asset turnover and reducing the debt levels. We liked what we heard, and we thought that the company was finally beginning to work for its shareholders. That's when we bought the shares (sometime in early 2015).

True to his word, Mr. Lo began to deliver. When the spin-off plan for Shanghai Xintiandi failed (due to valuation expectations), the company started selling assets piecemeal. The old CEO and CFO left the company. Even the development property sales began to accelerate (to be fair, that has more to do with the life cycle stage of the projects). Bond market has liked these actions and bond spreads have narrowed since. From yielding over 10%, the perpetuals now yield slightly over 5%.  For a bond offering announced last month, Shui On managed to raise USD250mm of 3 yr maturity funding for a coupon of only 4.375%. As bond investor, we have made money in Shui On's bonds. But alas, as a stock investor, we are yet to see any redemption.

But not enough

We held Shui On's shares for over eighteen months. During that time period, property prices in Shanghai, where bulk of Shui On's land bank and investment properties are located, are up 60%! As a stock investor, we are getting cautious about the stage of the cycle the property market in China. Several Tier 1 & 2 cities in China have announced tightening measures after seeing almost two years of strong property markets that have fueled significant property price hikes and we think Shanghai could be next.

Even more worrying signs for us as stock investor were Mr. Lo's statements at the 1H2016 analyst briefing we attended in August. When asked about the general outlook of China, Mr. Lo said he was 'worried.' That's the reason he gave for his preference for conserving cash, rather than spending it on share buybacks. But then he also said that he would like to shore up Shui On's land bank, given that more of its projects are reaching 'mature' stage. He lamented the 'aggressiveness' with which the local property companies were bidding for projects in Shanghai, which he claimed was pricing Shui On out.

At that meeting, we reached a conclusion. Mr. Lo, unfortunately, has still not started working for the shareholders. If he did, you would cancel all the plans for your company to buy additional land bank in this overheated market and divert that cash to aggressively buyback his company's shares. He is a smart businessman, so I hope he doesn't needed reminding that  at 0.38x Price to Book, he would need to spend only 38cents to a dollar to acquire more of his company. Even that book value is hugely understated according to his own presentation, since 74% of the company's land bank is stated at cost and not at market value.

At that presentation Mr. Lo proved that he, like many of your industry peers, have formed a habit of working for his bondholders, and his decision not to buyback his stock helped us to make ours. Last month, we sold our shares in Shui On Land. Including the dividends, we made an annualized 5% return on our investment. That is well below the average return of our fund, but that's better than RoE of Shui On Land. It is also vastly better than what the investors have done since the IPO. Against this, on Shui On's bonds, we have made annualized 12%+ returns. We are still holding on to the bonds, but the yield on them has fallen to only slightly above 5%, so they have already gone out of value territory.

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