Description

Cross-Harbour Holdings (0032.HK or CH) is an asset in transition, from a highly cash-generative infrastructure (Hong Kong tolls on tunnels) asset to a portfolio of financial assets. This transition has obscured intrinsic value. Moreover, the transition presents a couple different possible catalysts for realizing the intrinsic value that is much larger than market value.

Despite the meaningful market cap, the traded float has decreased considerably as a result of the recent tender. That might make this more accessible for PAs and smaller funds. That said, the valuation gap is sufficiently large here, and the non-controlled float still substantial, that there should still be considerable opportunity here.

CH has been written up twice in VIC before, once by manatee in 2015 and once by chewy in 2019. I think both writeups (especially manatee’s) do a fine job of describing the business as it has existed for most of its life, so I encourage you to skim those if you want more background. But my aim here is to make that unnecessary. Here I’ll instead be focusing on: a portfolio valuation (including significant upward valuation in book value due to portfolio assets), recent corporate actions, and potential catalysts.

CH has consisted of a number of different transportation-related assets in HK: the early operator of the Cross-Harbour tunnel, then the operator of the Western-Harbour tunnel, operator of Cairn’s tunnel, a driver’s education business, and an electronic toll technology licensing business. The majority of the cash flows have come from CH’s share of the Western Harbour concession, which expires mid 2023, at which point the cash flows of the business should plummet. The overhang of the disappearing cash stream is a major contributor to the opportunity here: both by discouraging potential investors, and also representing a catalyst for recognizing the considerable portfolio value.

As a starting point for our analysis, we’ll use the company’s reported book value from its 2020 semiannual report (in billions of HKD):

== Cash and ST deposits: 2.07

== Current financial assets: 2.46 [listed equities, debt, and funds]

== non-Current financial assets: 2.74 [marking other non-financial assets, like PP&E, the interest in the Western Harbour, and other interests, to 0]

== Total liabilities: 0.67

I’ve excluded any value from the remaining time on the Western Harbour tunnel concession, as well as the motor school and toll tech business, as I will attempt to account for their value separately. Using a method similar to manatee in the 2015 writeup, in the remaining legs of the concession, we conservatively see toll revenue of 750m (H2 2020), 1.5B (2021), 1.8B (2022), 1.1B (first 7 months of 2023), after accounting for Opex, Capex, and taxes, and attributing the half that belongs to CH, we get CH cash flow share of 280m, 560m, 676m and 376m, discounted at 8%, for an NPV of 1.5B HKD. These numbers are somewhat conservative in that 2021 revenues are kept in-line with the pandemic-stricken 2020 levels, despite early 2021 traffic patterns having risen from 2020. The motor school and toll tech revenues have been resilient through the pandemic, translating to 170m in earnings, which we conservatively value on an 8x P/E for 1.36B in value.

One additional adjustment to book value: in the recent crazed market environment the financial assets held by CH have appreciated substantially. Most notably, their large holdings in Evergrande Health (0708.HK) have increased 500%, translating to 2.7B HKD in additional portfolio gains. Although it is in principle possible they have reduced their holdings through the run-up, we have very strong reason to believe that is not the case based on available shareholding data in HK. Marking the rest of the portfolio with market prices, yields a net gain in book value of 2.58B HKD. Though it’s worth noting that much of this appreciation occurred in 2021, while the upcoming earnings will only reflect part of these gains through YE 2020.

This yields a base case 12.1B HKD in intrinsic value, or 32.46 HKD per share, compared to last of 13 HKD.

So there’s a substantial valuation gap. Now why (and when and how) do we expect that to be realised? As evidenced by the substantial Evergrande Health shareholdings, CH has not shown itself to be the friendliest stewards of capital, at least by our old-fashioned value standards.

Between a few different entities (Rose Dynamics, Chongqing Industrial, Cheung Chu Kiu, the chairman), 74.57% of the shares are effectively controlled by the chairman. He consolidated most of these holdings in Rose Dynamics through a recent tender at 14 HKD per share. We believe this tender was motivated by 3 basic forces: 1. The ability to purchase stock considerably below intrinsic value, 2. With the imminent curtailment of the major source of cash flow, the entity has outlived its purpose and is likely to be restructured, and 3. Activist attention (from Black Crane and Lanyon) in early 2020

The activist play essentially highlighted the obvious dynamic that’s suggested by the discrepancy between balance sheet and market value. The funds attempted to gain board seats and push to distribute via dividend the liquid assets. Their effort was unsuccessful, which does not seem surprising when considering the quantity of shares presumed to be held by associates of the Chairman. Only 4 months after the unsuccessful activist play, the Chairman launched the tender.

It warrants briefly discussing the portfolio. Portions of it seem to be invested in volatile, small-cap, unfortunate HK listcos. But also large portions seem to be invested prudently in tame, low vol debt and equity funds. The mismatch is confusing, and doesn’t offer us confidence that there’s value-minded investors at the helm. But we’re at least reassured that the more questionable elements of the portfolio have historically been a minority of the holdings (and have recently taken on a larger role only due to the impact of the unrealised gains). We’ve spent some time tracing through the questionable equity investments (in the spirit of David Webb), looking for evidence of wealth being siphoned off via fraudulent investment. We see no evidence of that, and indeed consider the risk of it much lower, now that the aggregated stake of the controller is transparent.

What comes next? The Western Harbour concession expires in July 2023, and expectations are that the government will assume the revenue risk, similar to their role on other tunnels in Hong Kong. It’s possible CH could remain involved as an operator, but this seems unlikely, and an operator like Serco, who currently operates the Cross-Harbour Tunnel (for which this company is named, and had its earlier involvement lapse), will take over. So you’re left with CH with nearly 11B HKD in relatively liquid equity (already roughly 9B), with comparatively minor ongoing earnings from the remaining motor school and electronic tool businesses. By far the most sensible outcome would be to liquidate most of the investment portfolio, dividend the proceeds, and then delist the small residual OpCo (or, alternately, leave it as a microcap). A less desirable, but plausible scenario, would be to deploy the excess liquidity into future infrastructure investments. The company has shown no significant appetite for this in the preceding years, so while we acknowledge this possibility, it does not seem likely. Although this is not the preferred scenario, the record of capital allocation (on infrastructure, contrasted to listed equities) seems strong, and accordingly we would project strong results. The least desirable scenario is status quo -- that CH remains as a thinly-veiled investment vehicle participating in puzzling private and public investments, doomed to trade at a significant discount. An intermediate outcome would be for the chairman to pursue a squeeze/take-out, to assume control of the missing 25%. They could do so at a significant premium to market value, but still significant discount to intrinsic value, thus still extracting substantial value

To be very clear, we don’t have any special insight into management’s plans here. We interpret the recent consolidating tender as both a positive and negative sign: negative in that it indicates a somewhat adversarial relationship between management and public shareholders; positive in that it seems consistent with a restructuring, and given the current valuation gap, many forms of restructuring should translate to the recognition of value. Put another way, the setup is bookended by the recent tender, and the looming cessation of the main tunnel business. And between those bookends there seem to be many potential catalysts in the form of CH clarifying its future plans. One such catalyst is the upcoming annual report and subsequent AGM. Again, it is possible that we get to July 2023 without clarification, but that seems not a favorite, and we’d argue we’re being well compensated for that risk. More concretely, at current prices, each of the next 2 earnings events should reveal substantial (1B HKD through 2020 YE, followed by 2B HKD for H1 2021) portfolio gains, which will dwarf earlier earnings, and potentially draw attention and catalyze investors motivated by a SOTP logic as outlined here.

The motor school and toll tech secondary seem to be reasonably high-quality, albeit small, businesses. We’ve assigned what seems like a very conservative multiple to them, and mostly not focused on them, given they seem very ancillary to the realization of value here.

One other encouraging data point on the potential for unlocking value: if you look back at the late 90s, early 00s, you can see periods of time with very high dividends. Although management was different at that time, this does represent another period where the business was in transition from Central-Harbour focused to Western-Harbour focused, and it resulted in the return of a significant portion of the market cap to shareholders. There are no assurances this will be repeated, but we consider it another encouraging datapoint towards our thesis.

In brief: CH presents the opportunity to invest in a bizarre portfolio at 40c on the dollar, with a near-term potential catalyst of the market realizing that portfolio has appreciated substantially, and a few medium-term catalysts of what is already substantively the case, becoming structurally clear, that CH is a portfolio shell no longer serving its original purpose. There’s no assurances on timeline, and it’s certainly possible that we’re sitting here in 5 years with a portfolio that’s lost 25%, and no meaningful action has been taken. But when we consider the many different possibilities that result in upside, and the incentives of the controlling stakeholder, we find this setup attractive

Risks: Two big ones, that can’t be understated:

== We haven’t seen evidence that minority shareholders are particularly aligned with the controlling stakeholder. There are plenty of ways for them to short-change us on value here. One mitigant: the chairman’s stake is so large, the risk/reward would not seem to justify much risk-taking in extracting value from the minority (more cynically, much of that extraction occurred in last year’s tender). A further mitigant: most scenarios involve the controlling stakeholder limiting our upside, but we still preserve a healthy return in most of those outcomes

== Bizarre capital allocation. It’s really hard to defend some of the equity investments (0718.HK, 0279.HK, 0622.HK, 2066.HK, 1387.HK). Even though they’ve been more than bailed out by the 0708.HK home run, we are troubled by these investments and think it’s reasonable to charge a significant haircut on the portfolio as a result

Catalyst

== Generally, the termination of the major source of cash flows, and need for strategic shift

== Reporting of significant portfolio gains from YE 2021 and H1 2021

== Follow-up to recent shareholding reorg through tender

== Capitalization on the near 75% ownership by the chairman, with an extreme chasm between market and intrinsic value