Description

A top-quality real estate portfolio in Hong Kong & Shanghai at a 16% net rental stub yield. Is this something that might be of interest to you? Yet another Asian holding company that has never traded close to NAV because of governance concerns and illiquidity? This liquid stock was trading at a 20% premium to NAV as recently as 2011. No distress (fortress balance sheet), with a transparent and good capital allocator since ‘91 that has fallen out of favour in the last 7 years.

We are recommending buying the publicly-listed family holding Hang Lung Group “HLG” which in turn owns 57% of Hang Lung Properties “HLP” and – importantly – some unquestionably high quality direct-owned real estate in Hong Kong and Shanghai. While we don’t believe HLP is a screaming buy given the overall peers’ NAV discounts that comes close (see later “Comparison of discount with peers”), we think that because of

1. an even higher NAV discount,
2. full consolidation accounting camouflaging direct-owned crown jewels

HLG is a baby thrown out with the HLP bathwater with a (1) much larger and (2) higher quality margin of safety.

While we wait for the enormous 61% margin of safety to close, we get paid a 4.1% dividend yield. 4.1% of share price coming out of a company whose NAV (and hence dividend cash) is valued at 39% on the dollar means we collect a positive carry on top of the underlying high-quality assets of 61% * 4.1% = 2.5% p.a., quite large for a risk-free cherry on top. Note the 61% discount is my own conservative estimate. The discount to (Savills' appraised) tangible book NAV is 69% for HLG.

Have a look below for the ownership structure. Note I scaled the assets surfaces proportional to their economic NAV to HLG.

Context

Hang Lung Properties “HLP” is originally a mall landlord and developer in Hong Kong. Under the leadership of Ronnie Chan who took the reign from his father in ’91, HLP slowly expanded to Shanghai (investment and construction in ‘90s; the two malls opened beginning ‘00s) and Tier-2 cities (investments and construction in ’00s; openings in ’11 - ‘15) building mostly luxury malls and adjacent offices and/or serviced residences. Mr. Chan has become an authority on Asian real estate markets in the media as he has an incredible track record in terms of timing. Reading 27 years of his shareholder letters is eye-opening as Mr. Chan’s main predictions and actions (i.e. in terms of both real estate investments, disposals and share or bond offerings/buybacks) prove prescient one or two years later (notably the Asian crisis and his patience in its aftermath).

Mr. Chan’s shareholder letters are somewhat like Berkshire’s in terms of consistency of strategy and clarity of communication. It is clear Mr. Chan is a business man genuinely interested in macro: just from listening to some of his speeches or talks (on YouTube, Bloomberg, CNBC for example) it is clear he is well connected with political contacts in the US (e.g. Obama administration, Kissinger), Russia, Europe and China and has a family reputation to protect.

Mr. Chan owns 37% of the publicly-listed family holding Hang Lung Group “HLG” which in turn owns 57% of HLP and some 100%-held real-estate investments in HK and Shanghai.

As we will see later, in the last years Mr. Chan has fallen out of favour with Mr. Market as the timing and execution of opening new malls in Chinese Tier-2 cities was bad. These malls opened during a Chinese “perfect storm” for luxury malls between 2011-2016 because of

1. export overcapacity pains to the economy
2. a government anti-corruption crackdown campaign that had a huge impact on luxury sales

We believe

• while real estate investors have control over timing of buying land and disposing of real estate, it is trickier to rightly time openings of shopping malls, which occur years after development starts
• many have forgotten Mr. Chan’s longer-term track-record
• because of a great timing track-record Mr. Chan’s ego has grown. Given he writes lengthy letters to shareholders, this communication poses a danger in the form of commitment bias: having already laid out his vision of wealth creation by building Chinese mall empire, more value destroying capex might occur to build mall in Tier-2 cities where Hang Lung is not the best or first developer
• however, the market is discounting Hang Lung so severely that we can buy at such a large margin of safety of top-quality Hong Kong and Shanghai malls value alone and get the Tier-2 malls for free on top. Even assuming for continued value destruction until ~2025 is not significant anymore to this thesis.
• China is embarking on a very large campaign to stimulate internal (and luxury) consumption

Interestingly, while Mr. Chan was correctly pessimistic about China in the ’11-’16 period citing “no end in sight”, and the current bearish macro in the news, Mr. Chan has recently turned bullish (i.e. see the annual report 2017 letter and especially in the H1 ‘18 letter).

We will now embark on the most important prong of this thesis, i.e. valuation: the reason to buy Hang Lung Group today is for deep value reasons (and getting paid to wait). The huge margin of safety on NAV and the low-volatile nature of the NAV (i.e. quality real estate in of cities) makes the risk-reward great here. For any more backdrop, we refer to the appendix for a corporate timeline, a short history of Ronnie’s capital allocation and a case why I believe Hang Lung has a competitive advantage in its business model that is well suited for sustainable luxury malls.

In the book Matchmakers on businesses with multi-sided networks, one chapter we recommend is devoted to malls: malls are middlemen for shoppers and brands. We believe Hang Lung’s fortress balance sheet and long-term oriented family business model are well-adapted to ultimately build, maintain and harvest these weak network effects. We have appended an empirical finance academic study by JPMorgan AM on the risk-adjusted superiority of large real estate properties, incidentally showing this “size effect” is largest in retail real estate. We believe weak network effects are amongst the reasons here.

Valuation

See our valuation below.

While the sell-side focuses an enormous amount of time on how the new Tier-2 malls are performing, i.e. the latest scare story, we can see these malls (while numerous) are not very significant to company’s total NAV, especially for HLG.

A few words on Hang Lung’s success in Shanghai: HLP owns the top mall in the whole city by rental density “Plaza 66”, and another mall “Grand Gateway” of which Hang Lung Group owns one of the office towers directly. These malls house the who’s-who of luxury brands. The unlevered gross rental return since opening are spectacular (a large part of Grand Gateway is currently under renovation).

For the Hong Kong assets, I will refer to HLP/HLG’s websites. These are mature quality properties with great occupancy and monotonically rising rents mostly in HK central. I value them at 6% gross cap rate.

In the middle column, I have illustrated how much of HLG’s gross asset value is in fact from direct-owned properties. We can see HLG owns the office tower in Shanghai (8.7% of its GAV), various properties in HK (2.3%) and a 20% stake in the Hong Kong Citygate JV development (with reputable peers such as Swire, Sun Hung Kai) which is still in part (~30%) under development (3.2% of GAV, seen in “other assets”).

14% of HLG GAV is from direct-owned great assets, while the 86% of GAV balance is from HLG’s 57% stake in HLP. Because HLG trades at such a steep discount, I argue these direct quality assets drastically alter the risk-reward of HLG and HLP in HLG’s favor as we will see later.

Some more info on the valuation sheet:

1. Net earnings yield (10% for HLG) is based on net profit after deducting gross profit from property sales & revaluations (hence only crediting rental income but still deducting G&A associated with the activities we leave out)
2. When we accordingly deduct non-earning properties under development or properties for sale from the market cap (30% of Citygate; Tier-2 malls under development after a 35% haircut to appraisal), we get a 16.7% “Net earnings yield excl. non-earning properties” or a net earnings yield of the core rental portfolio “stub”
3. a 4.1% dividend clipper of a company whose NAV is valued at 39% on the dollar is earning a 61%*4.1% = 2.5% positive carry on top of underlying assets performance to wait. Quite large for such a high-quality NAV

Lastly, I assume 45% of all 45 BHKD of development commitments of the company will be value destruction. While this is a simple extrapolation of the “perfect storm for Tier-2 cities” period of 2011-2016 (not sure if that is warranted), it should illustrate this value destruction is not so significant anyway. Ronnie Chan has compounded NAV at 13% p.a. since 2000.

Visualization of margin of safety: HLG versus HLP

Building on the shown SOTP valuation, I made a visualization to show the risk-reward of owning HLG is better than HLP. Note I am now showing EV / Total assets instead of market cap discounts to NAV.

Comparison of discounts with peers

See the comparables table and chart on the next two pages. In light green are most comparable peers based on geo & activities mix that I will discuss.

In one column I calculate “rental stub yield”. I deduct non-rent-earning properties for sale or under development from corporate earnings and market cap to see how much yield we get on the piece of market cap we pay for the core rental portfolio. This is rental yield net of corporate costs, interest, taxes (i.e. net income). The “% of GAV in dev or for sale” illustrates how much value the deducted “non-earning” part is. "Discount to NAV" in this case are pulled from Bloomberg.

What we see

1. the whole sector is cheap (see the historical discount to NAV chart), Hang Lung Properties has a discount to NAV of 53% while comparables Swire and Sun Hung Kai are at 37-39%, with smaller pure-HK player Hysan at 45%. Arguably those peers deserve more “conglomerate” discount as they are active in hotels, telco, transportation. Indeed, as seen in the graph below, they had higher discounts until HL fell out of favour as Tier-2 shopping malls opened in a weak Chinese environment and some operational trouble:
   1. HLP is cheaper but perhaps not a screaming relative buy. One could argue the discount is warranted because of higher Chinese exposure (not the top-notch Shanghai but 15% Tier-2 exposure)
   2. HLP does have the highest dividend. If sector stays cheap, HLP buyers get paid most for waiting, see “positive carry from dividend”
2. Hang Lung Group is really an outlier in terms of value, mouth-watering look-through net rental yield of 16.7%. It has a higher quality portfolio “buried” in consolidation reporting.
   1. To be fair, HLG has also the smallest market cap at 27 BHKD. Hopewell holdings is a comparable with an even lower market but smaller discount. Hopewell is a more complex story with much property under development and a highly valued toll-road and marginally profitable power plant which means that on a rental yield basis it isn’t that cheap (2.6% vs 16.7% for HLG)
3. HLG & HLP pop out
   1. with highest positive carry from dividend (getting paid to wait)
   2. both have quite a high proportion of GAV in non-earning properties for sale and under development. When these values are completed or sold, this can act as a catalyst on share price (using an earnings-based valuation) or dividend payout (more income to distribute)

As we see in the graph on the third page, the Hang Lung complex was the darling of the pack (trading at a premium of NAV) until 2011 when Tier-2 malls started opening in an unfavourable climate. These properties are still only 15% of HLP and 10% of HLG NAV but Mr. Ronnie Chan fell out of favour of Mr Market.  In fact, taking the biggest picture view on Bloomberg, Hang Lung has outperformed Swire & Sun Hung Kai since 2000 in terms of NAV appreciation.

Appendix

Timeline

Figure 4 Hang Lung annual report 2017. Not in this picture is Hang Lung bought much residential land in the aftermath of the ’98 Asian crisis (which it anticipated) almost timing the bottom after some patience in beginning ‘00s. The luxury residential properties were sold off opportunistically at the best moments reaping a ~60% profit margin mostly in ’05-’10.

Figure 5 Hang Lung annual report 2017

Company strategy: long-term orientation and fortress B/S suits its luxury tenants

I believe HL company strategy and owner-operator structure is well-suited for owning and operating luxury shopping malls. Its model has three pillars:

• HL aims to be the first mover in the best Tier-two cities. Reason is two-fold:

• Top pieces of developable land in the city centre have to be bought before they disappear. HL is very picky in terms of

1. location: ground zero of city centre with adjacent tube station and top landmarks nearby

2. size (large/huge): large shopping malls are ideal for families to spend a whole day

3. form: form is important as malls are designed by world-leading foreign architects. “We build world-class malls which will excel even if they are located in NYC, London, Paris” and “we want to educate the new Chinese consumers so that they will not find our buildings particularly beautiful today, but decades from now”

4. local government conditions

• Lock-in of top luxury tenants (Hermès, Zegna, Cartier, LV, Apple, Tesla etc.): luxury brands are much pickier on moving in a city’s second luxury mall

• Financial strength: Focus on quality instead of quantity of properties

• While many Chinese developers focus on deal-flow and sell properties to recycle (heavily taxed) capital into new projects, Hang Lung builds-to-own for the long term

• Net-debt-to-assets is between minus 10 and 20%. This is important because the strong balance sheet allows Mr. Chan to invest in continuous property upgrades, particularly profitable when vacancy is high and opportunity cost is low, i.e. in downturns, when competitors are cash-strapped. Another dubious practice of financially weak competitors is that they sometimes resell parts of newly developed malls. This often leads to management problems and fast decline in aesthetics

• Mr. Chan believes operating luxury malls requires retaining management experience in the company. HL has long-tenure managers. To foster this, he mentions “high salary is a necessity but not sufficient”, other factors are “decision power through a flat organization” (AR2010)

• Long holding period

• While management’s preferred holding period is multi-decade for malls, some opportunistic projects are carried out (luxury residential after Asian crisis, properties adjacent to malls) and sold opportunistically in 5-15 years

• HL’s predictable behaviour in keeping all malls in top condition is very attractive for local governments (and therefore in winning land auctions) as it guarantees a growing stream of rental and sales tax income from quality tenants.

HL claims its Shanghai mall rent per sqm is ~2x as high as close neighbours in the city centre and that inferior competitors in developing cities help attract more footfall to their malls (AR10).

A lot of high-end western brands are long-term partners with HL and have new HL malls on their shortlist because the company built a luxury mall brand in China that can only be achieved by players that walk the talk of long-term management of these properties. Luxury brands and local cities do not want to see malls depreciate and require continuous upkeep.

Why Hang Lung doesn’t do residential & office in China: circle of competence

Mr. Chan often reminds investors why HL restricts itself to quality malls and adjacent developments, especially in China. He thinks a foreign developer has absolutely no edge in doing vanilla residential in China (focus on quantity, fierce competition, more intensive/corrupt in terms of politics, more government intervention to keep residential prices from affecting social harmony while he prefers to forecast the market).

Conclusion

Reputation with luxury tenants and governments

There’s a couple of principals that HL has adhered to over decades that make it predictable and attractive to do business with, both from a western luxury tenant and local government perspective. In a way this is similar to unique reputation Berkshire enjoys in doing private equity transactions.

Long-term orientation in structure & philosophy

In a capital-intensive business as real-estate, especially when oriented toward luxury tenants, it is very important to minimize the principal-agent disadvantage that e.g. REIT’s have in terms of short-term orientation of non-owner managements. It I believe there’s a family owner advantage here.

Capital allocation: a history

Financing decisions

• Preference shares offering one month before share price peak in EoY ‘93

• 3BN HKD equity offering at share price peak ’96 before Asian crisis hit (remained net cash during and after Asian crisis)

• Five-year convertible bond raising 3.5BN HKD in 2002 (@3.4% p.a.) one year before market bottom in HK (to take advantage of low interest rates, equity raise deemed too dilutive, see chart!)

• Large 11BN HKD equity offering close to multi-year peak in Nov ’10 (before largest downturn on record in China)

Major investment decisions

• “Circle of competence”: Mr. Chan took control in 1991 and sold off all assets outside Hong Kong (North America, S-E Asia, Australia)
• Secured Standard Chartered Bank building in HK and made first China land investment in Shanghai (both in 1992) before turning bearish in the “speculator driven run-up” of 1993
• Bought HK land in auction at temporary market bottom in 1995, turned bearish years before Asian crisis of 1997, turned into net cash company just before the turmoil citing “speculators driven market”
• Bought HK high-end residential (harbour side) parcels in 2000 (2.6BN HKD) with almost no competition in wake of Asian crisis, but remained cautious “after price fall of 60%, [HK office/retail] market has further to fall”. Reason given: despite demand recovering, supply hitting market is even more, while luxury residential is supply-constrained. Office and general retail indeed fell further while high-end +- bottomed (see secondary lines on Bloomberg chart)
  • Most impressive feat: after being proved correct to call a top in ’98 and price fall of 60%, remains patient and negative for the foreseeable future two years later!
• Turned bullish on HK property after SARS dealt last blow in 1998-2003 downturn, called the bottom right at the exact right moment, waited to sell HK luxury residential inventory “action by inaction”, was called “lazy”
• Mr. Chan noticed that HL’s top Shanghai properties had consistently double-digit increasing rents and China (being still very domestic) didn’t feel any pain from Asian crisis, while HK had multi-year decline. HL’s two Shanghai complexes (opened in ’99 and ’01) were already yielding ~15% p.a. gross on an all-cost-allocated unleveraged basis in ‘06.
• Started buying Chinese land in smaller cities to be “first-mover” in luxury malls. Acquired most of its land in 2005-2006 after conducting studies of dozen Tier-two cities (5-15M inhabitants)
• Started selling HK luxury residential project faster in this period (after calling the bottom in ’03) to recycle cash into mainland investments
• Sold 29% of all luxury residential inventory opportunistically in the months before the financial crisis
• Hang Lung acquired two more parcels of land in May 2009 (+- market bottom).
• Note 1: HL did not buy any land 20 months before the market peak.
• Note 2: Chinese property prices only dipped very temporarily and reached previous heights 1-2 years later
• Starts developing all Chinese land into new malls
• HL starts major renovations in Shanghai after multi-year downturn hits 2011-2015 (rental opportunity cost lowest)

Mr Chan’s thoughts on Chinese malls today

Mr Chan had three worries in the last six years:

• Supports anti-corruption measures (started in ~2011) despite obvious negative impact to luxury malls. This pain is now over since a year or two and “with thriving tech sector, new types of more sustainable buyers have stepped in”.

• Chinese economy imbalances: was negative on the economy in ’11-’14 because of excess capacity in export businesses that government wants to get rid of. “We cannot see the end of the downturn frankly” – AR2014.

• Govt also has a plan to become more of a domestic consumption led economy with Chinese domestic consumption accounting for only 35% vs 70% of GDP for US

• Contrarian thought (AR2015): despite still being negative on economy, positive on the real estate sector in Tier-two as prices are very stable and volumes robust. Tier-three still oversupply, tier-one overheated. Leverage on developer B/S is at historical average

• E-commerce: despite e-commerce growing much faster >20% p.a. and marginal shops closing, shrinking supply will even benefit luxury malls at top locations (for any brand, consolidation in # of shops toward highest quality malls as a shop is increasingly being looked at as brand advertising as well. Already ’08-09 there emerged such an increased awareness by luxury tenants to avoid brand damage in mediocre/vacant malls). Cites European bank study that footfall in Chinese malls is higher than west, but spending much lower. Malls are looked at as an experience even more so in Asia. Mitigating factors Mr. Chan cites:

• Large malls so that families can spend an entire day

• Top malls with top tenants ~fully occupied = nice experience

• Top online-to-offline stores choose for top malls (Apple, Tesla, BMW, Xiaomi): focus is not on selling goods but advertising brand, enhancing customer experience, differentiating product, customer support

• Chan also notes that Tier-two and especially Tier-three cities already have higher e-commerce penetration vs the west due to inferior infrastructure (Beijing and Shanghai have lower e-commerce penetration). China is world-leader at almost 1/6 of total retail in e-commerce

H1 2017 letter (July 2017): turns unequivocally positive, longest and fiercest downturn in China is over. Tier-one cities luxury retail sales growth >20% sequentially (conf. call).

Retail sales are a leading indicator to mall rents, and tier-one cities are leading indicators to tier-two cities (6/8 HL malls in China are today in Tier-2 cities).

Leading indicator of rents

Figure 6 Conceptual representation of leading indicators for Hong Kong and Chinese mall rental growth. Based on industry reading and calculations.

Strengths

• Top aggregator of luxury brands in country with secular purchasing power increase and rising domestic consumption from a low base (35% of GDP). Internal consumption should grow a few percentage points per annum faster than GDP as China converges its consumption to developed countries (at 50-65% of GDP). On top of this, luxury consumption rises super linearly with purchasing power, especially when growing from a low base.
• Great capital allocator, multi-decade track-record, lucky coin-flipper if this is chance
• Corporate governance & transparency

Weaknesses

• Lack of political connections in China (mitigant is discussed in many chairman letters: pick only highest quality local governments in Chinese group of +80 cities with >5M inhabitants)
• Execution issues when expanding with new mall openings in Tier-2 markets in '11-'16
• Only one undeveloped top land plot in Hangzhou left (although 3 shopping centres in pipeline)

Opportunities

• expand luxury brand with quality tenants in vast & growing market of Tier-2 cities
• capitalize on any market weakness using fortress balance sheet (as done in the past)

Threats

• Quality real-estate is long-term bond proxy: rising interest rates affecting cap rate
• Increasing Chinese competition in quality luxury shopping malls (especially cities where HL is not yet present)
• Luxury sales diminish in e-commerce era?
• Increasing execution risk as the # of shopping malls grow (see Forum 66 Shenyang & Dalian)

Property by property data

Figure 10 Company data. LfL the malls are still growing rent strongly per sqm, but renovations have temporarily depressed rents.

Financials over time

Figure 11 Company data from 10 year financial performance chart in the annual report.

Interesting study academic study on the outperformance of large versus small shopping mall

In a nutshell, largest malls outperform with less volatility. Other “large” real estate outperforms but with slightly higher volatility. The reason is network effects (mall is an aggregator of tenants and shoppers) suck in new tenants from smaller malls in periods if rents become more affordable, limiting downside.

In Revisiting the Impact of Large Assets on Real Estate Portfolio Returns, authors find that larger office and multi-family properties outperform with slightly more risk, beating smaller properties on a risk-adjusted basis. Interestingly, large retail properties (i.e. large malls) outperform smaller counterparts widely with lower volatility.

Why? Outperformance might be explained by a higher land component as a percentage of the total property’s worth. This means a smaller piece of NAV is in a depreciating asset (i.e. the building). As for lower asset volatility, in a general downturn of rents, office but especially mall tenants in lower quality assets or locations to upgrade towards more quality/larger malls. This limits rental downside for the largest high-quality assets. Given that China has an oversupply of mediocre malls, I believe this effect should play out even more for Hang Lung.

The authors note that the market prices in this extra rental upside potential by assigning a lower cap rate (i.e. a higher P/E ratio) to larger properties in all real estate types. The premium just did not prove enough in the past, which explains the outperformance.

Figure 12 Revisiting the impact of large assets on Real Estate Portfolio Returns by Esrig, Hudgins and Cerreta - Journal of Portfolio Management

Catalyst

• main thesis is dividend yield & deep value on stable quality assets is its own reason to buy

Minor catalysts:

• if Mr. Chan keeps with his recent and contrarian market optimism, dividend growth resuming from '19-20
• sale of last luxury residential properties at 60% profit margins, highlighting value booked at depreciated cost on balance sheet