Midland IC&I 459
July 24, 2013 - 2:02pm EST by
jt1882
2013 2014
Price: 0.05 EPS ? ?
Shares Out. (in M): 13,700 P/E ? ?
Market Cap (in $M): 617 P/FCF ? ?
Net Debt (in $M): -488 EBIT 0 0
TEV ($): 129 TEV/EBIT ? ?

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  • Hong Kong Real Estate
  • High ROE
  • Discount to book

Description

(apologies, this writeup was originally drafted when the stock price was $0.045, $0.001 less than the closing price of $0.046 today)
 

Summary:

This is a recommendation to buy shares in Midland IC&I (459 HK).  Midland IC&I (“IC&I” stands for Industrial, Commercial, and Investment) is the 71%-owned commercial property division of Midland Holdings (1200 HK), Hong Kong’s leading property brokerage.  In 2012 Midland IC&I accounted for 21%, 58%, and 38% of Midland Holdings’ consolidated revenue, pre-tax profit, and net cash, respectively (2011 equivalent ratios: 13%, 51%, and 33%).  Midland IC&I has a HK$617 million market cap and Midland Holdings has a HK$2.2 billion market cap.   

 

I think Midland IC&I shares are a “buy” for two main reasons:

 

1) Midland IC&I is a “heads you win, tails you don’t lose much” business: a leading Hong Kong commercial property brokerage (i.e. 10-20% estimated market share) with minimal fixed costs/assets that has not lost money on a cash basis since at least 1995 when it was still an unlisted subsidiary of Midland Holdings.  Since Midland IC&I went public in 2007, it posted average annualized ROE of 25%.  Excluding cash, most of which was not needed to run the business, the average annualized ROE over this period was 180%.  A good balance of volatile sales commissions and steady leasing commissions means Midland IC&I should remain profitable in almost any environment.

 

2) Midland IC&I is selling for a “heads you win, tails you don’t lose much” price: 0.6x 2012 EV/EBIT, 3.5x 2012 P/E, 0.96x book, 1.26x net cash, or a 2% discount to net net current assets plus non-core property.  This has to be one of, if not the, cheapest major metropolitan commercial property brokerage in the developed world today (Taiwan’s Sinyi Realty 9940 TT is the closest comparable).

 

Why are Midland IC&I shares cheap?  Because the market is currently focused on an unprecedented and  controversial legislative proposal (the “double stamp duty”, more on this below) designed to deter commercial property speculation that I think will either A) only temporarily become actual law, or B) get vetoed/amended by Hong Kong’s Legislative Council.  All the short-term attention on proposed legislation has obscured the long-term potential for Midland IC&I to keep growing as Hong Kong tackles severe shortages in both office and retail space over the next decade. 


Important background sources:

 

 

Frequently asked questions:

What is Midland Holdings?  

Founded in 1973 and IPO’d in 1995, Midland Holdings is Hong Kong’s leading property brokerage: today it employs 5,300 of the 37,000 property agents in Hong Kong.  Midland’s bread-and-butter business has always been residential broking where it has 25-30% commission market share, a similar level to long-time rival Centaline (unlisted).  The “Midland” brand is a household name in Hong Kong, and it’s hard to walk anywhere in the city without spotting one of their 383 retail branches http://en.wikipedia.org/wiki/File:Midland_Realty01.jpg (note: there are more Midland branches than McDonalds and Starbucks combined).  Except for some branches in the most prime locations, all Midland retail branches are rented and directly operated, with no franchisees.

Today Midland Holdings is still managed by its co-founder Freddie Wong, the largest individual shareholder (12% stake).  Wong succeeded in growing Midland’s Hong Kong residential sales market share over time without sacrificing commission pricing thanks to long-term relationships with property developers that gave Midland semi-exclusive access to primary sales of new housing projects.  In Hong Kong, Midland and Centaline are basically the only two brokers that compete in primary residential sales, while over 500 brokers compete in the secondary market ( http://asiaresearch.daiwacm.com/eg/cgi-bin/files/20130304hk_Midland.pdf#page=1). 

As a result, Midland Holdings’ shareholders have been richly rewarded: book value per share grew from HK$0.35 in 1995 to HK$2.24 in 2012, while HK$2.99 per share in cash dividends was paid out along the way.  Midland Holdings’ profits have been remarkably resilient through good and bad times (i.e. positive operating cash flow since at least the ’95 IPO), and its +817% total return over the last 10 years (June 2003 to June 2013) is higher than all but about 100 of the 1,600 companies listed in Hong Kong.

 

What is Midland IC&I?

Midland Holdings branched out into commercial property broking in 1982.  The business segment created for commercial broking was called Midland IC&I, and it remained a profitable but minor P&L contributor to Midland Holdings until the mid 2000’s as you can see from the track record below (note: the post-2007 figures are from Midland IC&I’s annual reports, while the pre-2007 figures are from Midland Holdings’ annual segment breakdowns). 

(Currency: HK$)

2012:     revenue = 813m,              EBIT = 207m,      equity = 642m  

2011:     revenue = 456m,              EBIT = 117m,      equity = 464m

2010:     revenue = 533m,              EBIT = 157m,      equity = 373m  

2009:     revenue = 381m,              EBIT = 109m,      equity = 252m

2008:     revenue = 258m,              EBIT = 1m,           equity = 175m  

2007:     revenue = 464m,              EBIT = 100m,      equity = 176m

2006:     revenue = 295m,              EBIT = 65m,         equity = 50m

2005:     revenue = 279m,              EBIT = 48m,         equity = 42m

2004:     revenue = 281m,              EBIT = 59m,         equity = not disclosed

2003:     revenue = 127m,              EBIT = 21m,         equity = not disclosed

2002:     revenue = 83m,                EBIT = 11m,         equity = not disclosed

2001:     revenue = 74m,                EBIT = 5m,           equity = not disclosed

2000:     revenue = 71m,                EBIT = 6m,           equity = not disclosed

1999:     revenue = 59m,                EBIT = -1m,         equity = not disclosed

1998:     revenue = 65m,                EBIT = -8m,         equity = not disclosed

1997:     revenue = 178m,              EBIT = 24m,         equity = not disclosed

1996:     revenue = 105m,              EBIT = 26m,         equity = not disclosed

1995:     revenue = 48m,                EBIT = 4m,           equity = not disclosed

 

The management of Midland Holdings eventually decided that Midland IC&I needed to be spun-out as a separately listed subsidiary in order to boost staff morale, incentives, accountability, etc.  So in 2007 Midland IC&I was injected into a listed shell company that Midland Holdings already controlled. 

The whole process went like this: in 2005 Midland Holdings paid HK$108 million for 4.3 billion new shares (52% of the then-enlarged share count) of a listed shell company called EVI Education (stock ticker: 8090 HK).  Then in 2007, Midland Holdings sold its entire commercial property division to EVI Education in return for HK$100 million cash a HK$540 million note due June 2012 that would automatically convert into 5.4 billion new shares of EVI Education (or 39% of the 13.7 billion share fully diluted share count).  So the 2005 share placement and 2007 convertible note enabled Midland Holdings to swap their unlisted commercial property division (Midland IC&I) for 71% of a listed company whose name (ticker) they eventually changed from EVI Education (8090) to Midland IC&I (459).  

 

Midland IC&I’s revenue derives entirely from commissions on commercial property transactions, either sales/purchases or leases.  On sales/purchases, Midland IC&I earns commissions worth 1% of the transaction value from the both the buyer and the seller (i.e. 2% total), minus any discounts/rebates.  On leases, Midland IC&I earns commissions worth half a month’s rent from both the lessor and lessee (i.e. 1 month total), minus any discounts/rebates.

 

 

What is Special about Midland IC&I?

 

                Midland IC&I is unique among Hong Kong commercial property brokerages for following reasons:

 

1)      Strata-title advantage: Midland IC&I leveraged the goodwill of the parent company’s “Midland” brand among mass-market residential property investors (i.e. individuals and small businessmen) to create a commercial property brokerage similarly focused on the “small guy,” strata-title demographic – a demographic that large foreign competitors CBRE, Jones Lang Lasalle, Cushman and Wakefield, Savills, etc. have not traditionally served. 

 

Granted, giant foreign brokerages like CBRE have an edge over Midland IC&I in big ticket grade A office transactions for institutional tenants in prime, single-landlord buildings.  Since only 20% of Hong Kong’s existing grade A office stock is under strata-title ownership, that formula has worked well so far (see http://www.joneslanglasalleblog.com/APResearch/office-research/kowloon-east-%E2%80%93-a-resilient-strata-titled-office-sales-market#.UeydadJ312A).

 

But guess what?  Most of Hong Kong’s new office supply coming online is going to be in strata-title and/or small floor-plate offices away from Central, the traditional CBD where office supply hasn’t meaningfully increased in a decade (see page 14 http://asiaresearch.daiwacm.com/eg/cgi-bin/files/HKOfficeMarket_2012Autumn.pdf).  Even giants like CBRE recognize this, and as their recent pre-sales ad for Rykadan Capital Tower (a new strata-title office in Kowloon) suggests https://www.dropbox.com/s/zbj5hutawsg6qfr/CBRE%20strata%20ad.pdf, strata-title sales is where the future action is going to be. 

 

Yet the marketing of strata-title properties is labor intensive.  Most brokers don’t have the manpower it takes, but Midland IC&I does with over 800 total employees.  I’ve spoken to people at competitors like Savills – not only are they too outmanned to focus on strata-title property (Savills has less than 100 agents in HK), but they even seem look down on strata title properties because of the perception that chopped-up building ownership leads to poor management/maintenance (see the latest Savills presentation here, page 32, where they characterize strata-title property as “unsuitable” https://www.dropbox.com/s/om2vtosjw93rx6i/Savills072013.pdf).  Centaline CIS http://www.centaline-oir.com/?lang=en-us, the commercial property arm of Centaline (Midland’s longtime rival in residential property), appears to be the only other brokerage with the manpower (also +800 employees) to compete with Midland IC&I in strata-title transactions, but since they aren’t a listed company we don’t know much about them.  

 

2)      Branch network advantage: Midland IC&I’s hidden asset is its ability to rely on a steady stream of client referrals from parent Midland Holdings’ 383 retail branches.  Those branches (most of which are street-level) generate lots of “walk-in” inquiries by individuals and small businessmen – ideal clients for the offices, shops, and industrial properties that Midland IC&I markets.  

 

Midland IC&I has a small retail network of its own (20 branches) that it pays rent on, but it does not cover any rent/overhead for the 383 retail branches managed by Midland Holdings.*  Midland IC&I does, however, compensate Midland Holdings for any referrals by way of a 50/50 split-commission “cross-referral” agreement (see http://www.hkexnews.hk/listedco/listconews/SEHK/2012/1031/LTN20121031719.pdf).  The details in the October 2012 cross-referral agreement above are very interesting: not only have historical referral commissions been increasing, but forecasted referral commissions are also expected to rise too

 

Although this internal forecast was done some months before the government’s announcement of unprecedented stamp duties on commercial properties (more on this below), it is interesting to see how bullish Midland IC&I / Midland Holdings were feeling on their cross-referral cooperation.  Indeed, my recent meeting with the CEO of Midland IC&I revealed that in some years up to 20-25% of total revenue can come from these client referrals.

 

* It’s also important to note that Midland Holdings shrewdly acquired a few dozen of its most prime retail branches decades ago, so the walk-in business generated by those branches is completely free of any rental burden or landlord risk.

 

3)      Lean, variable cost structure:  Thanks in part to the lack of branch rental expenses (see above), Midland IC&I enjoys an extremely lean and variable cost structure. 

 

Midland IC&I’s single largest business cost is employee compensation (i.e. salary and bonus).  Fixed salaries for Midland IC&I’s property agents average a paltry HK$6,000-8,000 per month (i.e. assuming a 40 hour work week, this is barely above Hong Kong minimum wage!).  Cash bonuses are entirely based on commission productivity: the typical Midland IC&I agent earns 10-30% of the commission dollars they generate (adjusted for cash flow risks like whether or not the purchaser eventually defaults, etc.).  In addition, underperforming agents (i.e. the bottom 10%) are regularly fired – in Hong Kong you can do this with no red tape, delay, or extra compensation. 

 

So despite being exposed to cyclical/volatile revenues, by skewing compensation heavily in favor of performance bonuses (i.e. bonus/salary ratios ranged from 1.0 to 3.3 in the last 6 years) Midland IC&I’s been able to keep staff costs as a percentage of revenue in a very tight range: 50-53% from 2007 to 2012.  This is the key reason why Midland IC&I has never lost money on a cash basis since  at least 1995.

 

Other expenses – commission discounts (rebates), advertising, rental expenses, accounts receivable impairments, depreciation, etc. – are somewhat less variable, but still enough within management control so that they can be scaled down when business is slow.  As a percentage of revenue, these other expenses have ranged from 21-49% between 2007 and 2012.    

 

4)      Leasing revenue – handy in tough times:  even though sales and purchases grab all the headlines when it comes to Hong Kong property broking, leasing plays an important behind-the-scenes revenue generation role, too.  Regardless of what’s happening in the macro economy, there’s always going to be tenants that need to upgrade/downgrade their commercial space requirements; the leasing commissions those “churners” generate will always be there.  Thus, property brokers that can capture a meaningful share of leasing commissions will have a stable stream of back-up revenue even when the environment for sales/purchases is weak like it is now (more on this below).

 

According to the CEO of Midland IC&I, leasing revenue accounts for a significant percentage of total revenue.  He declined to give us the exact ratio for 2012, but he hinted that the normalized sales/leasing revenue split over the long-run was roughly 70/30.  He also said that since government intervention in the commercial property market started in February 2013, there have been some months where leasing as a percentage of revenue even approached 90%.

 

So it’s safe to say that Midland IC&I has a meaningful chunk of leasing revenue to fall back on.  The same can’t be said, however, for parent company Midland Holdings, where leasing as a percentage of revenue was just 5-9% between 2008 and 2012.  This lack of leasing revenue, coupled with the with large retail branch rental expenses, is why profits at Midland Holdings are far less resilient in tough times than at Midland IC&I.  A prime example of this can be seen in the recent profit warnings both companies announced a few weeks ago: while Midland IC&I informed shareholders to expect less profit for the first half of 2013 http://www.hkexnews.hk/listedco/listconews/SEHK/2013/0703/LTN20130703346.pdf, Midland Holdings informed shareholders to expect a loss for the same period http://www.hkexnews.hk/listedco/listconews/SEHK/2013/0703/LTN20130703344.pdf.

 

5)      Primary sales commissions – where the real money is made: a quick look on page 10 of this 2012 results presentation https://www.dropbox.com/s/wc26fg49zr06v0b/2012%20results%20presentation.pdf reveals a key driver behind Midland Holdings’ success over the last decade: primary residential commission rates (the left-hand chart), which jumped from 1.1% in 1999 to 2.7% in 2012.  Midland Holdings achieved this by convincing developers to outsource more and more of their primary residential marketing burden in exchange for brokerage exclusivity (or semi-exclusivity).** 

 

Though it’s still early days, Midland IC&I appears to have a good opportunity to establish a similar niche in primary commercial property sales by emphasizing its expertise in strata-title units; some local developers already recognize Midland IC&I for this capability.  The new “t.mark” shopping mall in Tsuen Wan (see top of page 4 https://www.dropbox.com/s/wc26fg49zr06v0b/2012%20results%20presentation.pdf) is a good recent example: thanks to its sway among individual/SME commercial property investors, Midland IC&I was appointed the sole agent on this 233-unit strata-title shopping mall and earned a hefty 4-5% commission on each sale.

 

According to Midland IC&I’s CEO, exclusive primary transactions like the t.mark are still a small portion of total revenue (he wouldn’t specify the exact breakdown, but I’m guessing it’s no more than 10%).  Still, he agreed that primary strata-sales are a great long-term opportunity: if Midland IC&I can figure out how to do more of these exclusive, fat commission primary deals they should enjoy a P&L boost just like Midland Holdings did when it conquered the primary residential market.

 

**Why weren’t primary buyers deterred by the tripling of primary commission rates at Midland Holdings?  Probably because such a high percentage of them were new money mainland Chinese (i.e. they accounted for 43% of primary luxury residential purchases as recently as 1Q2012).   Likewise, primary sellers (developers) probably found it easy to accept Midland Holdings’ higher commission rates because of the premium prices their new projects achieved (in Hong Kong, new homes have long-held wide price premiums over equivalent sized older homes), even on a pre-sales basis.

 

 

 

What is the Double Stamp Duty (DSD)?     

 

Background:  the Hong Kong government has been very concerned about rising property prices in the city since the global financial crisis.  This concern was initially focused on the residential market, so the administration introduced a series of proposed stamp duties designed to cool down home prices. 

 

To thwart short-term speculators, the “Special Stamp Duty” or SSD (http://www.ird.gov.hk/eng/faq/#a01) was introduced in 2010: this levied a 15% stamp duty on homes sold within 24-36 months of purchase.  The SSD ultimately failed to cool home prices, so a new “Buyer’s Stamp Duty” or BSD (http://www.ird.gov.hk/eng/faq/#bsd) was introduced in 2012 to thwart foreigners: this levied a 15% stamp duty on buyers without a permanent Hong Kong ID card.  So far, the SSD/BSD have only succeeded in lowering residential transaction volumes, not prices.  

 

Meanwhile, volumes and prices of non-residential properties – i.e. offices, shops, car parks, etc. anything still exempt from punitive stamp duties – kept rising, especially in late 2012 after the BSD was announced.  When the government noticed this, it decided to intervene in the non-residential property market for the first time ever and introduce the “Double Stamp Duty” or DSD (http://www.ird.gov.hk/eng/faq/#avd).  The DSD basically levies a 1.5%-8.5% upfront stamp duty on both residential and non-residential property transactions (details: http://www.colliers.com/~/media/files/marketresearch/apac/hongkong/white-paper/hk-cooling-mar2013-r.ashx).  Like the SSD and BSD before it, the DSD has only succeeded in lowering non-residential transaction volumes, not prices.

 

It’s only a legislative proposal, not a law (yet):  The SSD, BSD, and DSD have been very bad news for property brokers in Hong Kong.  As you can see from the Hong Kong Land Registry’s monthly updates http://www.landreg.gov.hk/en/monthly/agt.htm, in June 2013 total sales volume (i.e. the number of agreements for sales/purchases for both residential and non-residential properties) was just 4,616.  This is down from 8,389 in June 2012 and 11,601 in June 2011.  In other words, there were 8 property agents fighting for every 1 transaction last month.  The market lull is literally starving Hong Kong’s property agents (see http://www.thestandard.com.hk/news_detail.asp?we_cat=16&art_id=135399&sid=39938217&con_type=3&d_str=20130711&fc=7), so if transaction volumes don’t improve some brokerages will definitely go bust.  Even Midland Holdings recently warned shareholders that the six months ending June 30 will be loss-making (Midland IC&I warned shareholders to expect significantly less profit, but at least there’s profit!).

 

Given the effect SSD/BSD/DSD news has already had on the market, one could be forgiven for thinking these stamp duties were already enacted as legislation (many media outlets certainly give that impression).  The truth is these stamp duties ARE STILL JUST LEGISLATIVE PROPOSALS (seehttp://www.legco.gov.hk/yr12-13/english/bc/bc01/general/bc01.htm and  http://www.legco.gov.hk/yr12-13/english/bc/bc05/general/bc05.htm).  

 

Hong Kong’s Legislative Council (Legco) has the power to veto these bills, and there is a groundswell of smart, influential people like David Webb (webb-site.com), the American Chamber of Commerce, KPMG Tax, etc. that are making the case for a veto on the grounds that the bill 1) makes no policy sense, 2) is riddled with loopholes (i.e. property transacted via shell companies can avoid stamp duties altogether, see http://webb-site.com/articles/dsd2.asp) and 3) is unconstitutional.  28 delegations recently submitted convincing arguments against the DSD, and you can read their position papers here http://www.legco.gov.hk/yr12-13/english/bc/bc05/agenda/bc0520130613.htm.  

 

Despite popular opinion, Hong Kong’s Legco is not a rubberstamp legislature, and there is definitely discord within their ranks on these stamp duty bills.  Weeks ago I attended a panel discussion breakfast on the Double Stamp Duty hosted by the Canadian Chamber of Commerce http://www.cancham.org/asp/calendar_detail.asp?item=B8SXHC308.  Two of the panelists were Legco members from different political parties – Emily Lau (Chairperson of the Democratic Party) and Tommy Cheung (Liberal Party).  Both openly expressed dissatisfaction with the stamp duty amendment bill in its current form and Emily Lau even quipped something to the effect of “I can guarantee this bill will not pass easily.” 

 

Even more interestingly, Starry Lee of the “pro-Beijing” DAB party (stands for Democratic Alliance for the Betterment and Progress of Hong Kong) was recently quoted stating her party might vote against the bill http://www.scmp.com/business/article/1277576/opposition-hong-kong-property-stamp-duty-rise-grows-vocal. How significant is that comment?  Hong Kong’s Legco has only 70 seats, of which 43 are “pro-Beijing” (i.e. supposed to do what the Beijing-appointed administration says).  The DAB alone accounts for 13 of those 43 pro-Beijing seats; no other pro-Beijing party holds more seats.  So if this bill is causing dissension even amongst the pro-Beijing legislators, then there must be some chance – however small – that that the bill is eventually amended or vetoed. 

 

Here’s another way to think about the stamp duty bill: these proposals were the brainchild of the Chief Executive of Hong Kong, Mr. CY Leung, a person who used to be an elite Hong Kong property broker himself (first with Jones Lang Lasalle, then his own company which he ultimately sold to DTZ)!  With that piece of history in mind, it strikes me as silly to bet that CY Leung allows his stamp duties to put all his former property broker colleagues/competitors out of business, especially since the CEOs of the biggest brokerages (i.e. Midland and Centaline) probably still have his personal contact to lobby him directly.  It is not an exaggeration to say that CY Leung owes some of his past success to companies like Midland.  For proof we needn’t look any further than to see who was hired to prepare the property appraisals for Midland’s 1995 IPO (see https://www.dropbox.com/s/65v5y54o0v73lns/MIDLAND%20IPO%20cdv074.pdf page 79 of the PDF file)!

 

                 

The Big Picture (my two cents):

All this short-term attention on the double stamp duty has obscured the long-term growth potential for an established brokerage with strata-title expertise like Midland IC&I in office, industrial, and retail property. 

 

A large chunk of the new office supply that’s coming online in the next several years is slated to be strata-title and/or small floor space units – a huge opportunity right up Midland IC&I’s alley (see https://www.dropbox.com/s/om2vtosjw93rx6i/Savills072013.pdf page 30-33 and http://asiaresearch.daiwacm.com/eg/cgi-bin/files/HKOfficeMarket_2012Autumn.pdf page 14).  But this supply won’t be enough – all analysts agree that there is a severe shortage of office space in Hong Kong, and it’s projected to get worse over the next decade unless the government moves heaven and earth to create a lot more supply than has been planned so far. 

 

Of the office supply that is yet to be planned but needs to come online in the next decade, a lot of that could come from conversions of old industrial buildings.  The Hong Kong government fortunately realizes how important this is to creating new space, and has exempted these industrial conversion properties from land premium payments – a key incentive to attract industrial re-developers (see video http://www.bloomberg.com/video/hk-s-industrial-properties-lure-new-investors-Pxq0A8ezTayVLSJC2tMTAg.html).   According to Colliers http://www.colliers.com/en-gb/hongkong/about/media/2013-06-20-kowloon-pc, even though 88% of the 1,500 industrial buildings in Hong Kong are eligible to be converted into modern commercial usage, only 6% of these buildings have made an application to convert so far.  So industrial redevelopment is still an enormous opportunity, and since most industrial buildings are strata-owned by individuals and small local companies to begin with, there’s a very big role to play for Midland IC&I here too.

 

Thanks to the introduction of the Individual Visit Scheme http://www.tourism.gov.hk/english/visitors/visitors_ind.html in 2003, millions of mainland Chinese tourist shoppers (i.e. 3-4 million per month) that don’t trust product quality back home have sent Hong Kong retail sales, retail rents, and retail capital values sky-rocketing.  Tiny street-front shops in once quiet neighborhoods are suddenly receiving huge foot traffic and getting sold for hundreds of millions of Hong Kong dollars.  International brands that never considered selling in Hong Kong before like Top Shop, Victoria’s Secret, etc. have opened flagship stores in the last year alone.  Unless mainland Chinese consumption taxes go to zero and product selection/quality improves a lot, then Hong Kong’s role as China’s duty-free mall should not be threatened too much (after all, 75% of the 1.34 billion people in mainland China have yet to be approved to visit Hong Kong under the Individual Visit Scheme!).  This China-driven retail story is a huge long-term brokerage opportunity for Midland IC&I, and the CEO mentioned they’ve been busy building out their retail team to compete more effectively, especially in primary strata-sales (i.e. the t.Mark mall in Tsuen Wan).

               

None of the above long-term growth opportunities are going to disappear from Midland IC&I’s horizon just because the government wants to charge double stamp duty for a little while.  If anything, the double stamp duty has done Midland IC&I a huge favor so far by weakening its competitors, few of which have the variable cost structure and cash hoard to survive a prolonged slump in transaction volumes. 

 

Will Midland IC&I actually capitalize on all these opportunities? Only time will tell, but Midland IC&I’s current valuation – below book, 1x liquidation value, etc. – is not much to pay to find out.

 

 

 

Risks/concerns:

No dividends (yet): The biggest problem I have with Midland IC&I is that it has never paid a cash dividend.  This is possibly because Midland IC&I was until very recently a small spin-off company still in operating in “start-up” mode, so formulating a dividend policy was not a priority.  But that in itself is strange because Midland IC&I’s parent company, Midland Holdings, has one of the most impressive dividend track records in Hong Kong over the last two decades.   Midland IC&I has achieved high ROEs in spite of its ballooning cash pile, but that can’t continue indefinitely.

 

Something will have to be done Midland IC&I’s cash at some point.  It could be spent on M&A, but Midland IC&I’s CEO told me he’s personally not a fan of acquisitions in the brokerage industry and would rather hire talented people away from rivals.  The other alternative – that the cash eventually gets up-streamed to Midland Holdings – sounds exciting.  But this could be done various ways, like via a cash dividend (great for Midland IC&I shareholders), or via something underhanded like a loan to related companies (bad for Midland IC&I shareholders).  Either way, there is definitely a need for Midland IC&I’s cash at the Midland Holdings (parent) level because A) its residential brokerage lost money in the first half and B) generous dividend payments have depleted the parent-level cash balance in recent years.

 

In my discussions with Midland IC&I and Midland Holdings, I got the impression that they were fully aware of this cash pile and that their goal is to eventually do something sensible.  From what I can tell Midland Holdings has not done very much to engender mistrust; it has certainly created great wealth for its shareholders over the decades. The only connected transactions you can find at Midland Holdings going back to 1999 are deals where the CEO Freddie Wong hired Midland Holdings to broker properties he owned personally (he paid market price commissions on these deals, and never sold/bought anything into/out of the listed company).

 

 

 

 

I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Catalysts: surprise dividend payment, privatization (there have been change-of-control rumors at the parent level in the past), earnings growth via primary market sales
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    Description

    (apologies, this writeup was originally drafted when the stock price was $0.045, $0.001 less than the closing price of $0.046 today)
     

    Summary:

    This is a recommendation to buy shares in Midland IC&I (459 HK).  Midland IC&I (“IC&I” stands for Industrial, Commercial, and Investment) is the 71%-owned commercial property division of Midland Holdings (1200 HK), Hong Kong’s leading property brokerage.  In 2012 Midland IC&I accounted for 21%, 58%, and 38% of Midland Holdings’ consolidated revenue, pre-tax profit, and net cash, respectively (2011 equivalent ratios: 13%, 51%, and 33%).  Midland IC&I has a HK$617 million market cap and Midland Holdings has a HK$2.2 billion market cap.   

     

    I think Midland IC&I shares are a “buy” for two main reasons:

     

    1) Midland IC&I is a “heads you win, tails you don’t lose much” business: a leading Hong Kong commercial property brokerage (i.e. 10-20% estimated market share) with minimal fixed costs/assets that has not lost money on a cash basis since at least 1995 when it was still an unlisted subsidiary of Midland Holdings.  Since Midland IC&I went public in 2007, it posted average annualized ROE of 25%.  Excluding cash, most of which was not needed to run the business, the average annualized ROE over this period was 180%.  A good balance of volatile sales commissions and steady leasing commissions means Midland IC&I should remain profitable in almost any environment.

     

    2) Midland IC&I is selling for a “heads you win, tails you don’t lose much” price: 0.6x 2012 EV/EBIT, 3.5x 2012 P/E, 0.96x book, 1.26x net cash, or a 2% discount to net net current assets plus non-core property.  This has to be one of, if not the, cheapest major metropolitan commercial property brokerage in the developed world today (Taiwan’s Sinyi Realty 9940 TT is the closest comparable).

     

    Why are Midland IC&I shares cheap?  Because the market is currently focused on an unprecedented and  controversial legislative proposal (the “double stamp duty”, more on this below) designed to deter commercial property speculation that I think will either A) only temporarily become actual law, or B) get vetoed/amended by Hong Kong’s Legislative Council.  All the short-term attention on proposed legislation has obscured the long-term potential for Midland IC&I to keep growing as Hong Kong tackles severe shortages in both office and retail space over the next decade. 


    Important background sources:

     

     

    Frequently asked questions:

    What is Midland Holdings?  

    Founded in 1973 and IPO’d in 1995, Midland Holdings is Hong Kong’s leading property brokerage: today it employs 5,300 of the 37,000 property agents in Hong Kong.  Midland’s bread-and-butter business has always been residential broking where it has 25-30% commission market share, a similar level to long-time rival Centaline (unlisted).  The “Midland” brand is a household name in Hong Kong, and it’s hard to walk anywhere in the city without spotting one of their 383 retail branches http://en.wikipedia.org/wiki/File:Midland_Realty01.jpg (note: there are more Midland branches than McDonalds and Starbucks combined).  Except for some branches in the most prime locations, all Midland retail branches are rented and directly operated, with no franchisees.

    Today Midland Holdings is still managed by its co-founder Freddie Wong, the largest individual shareholder (12% stake).  Wong succeeded in growing Midland’s Hong Kong residential sales market share over time without sacrificing commission pricing thanks to long-term relationships with property developers that gave Midland semi-exclusive access to primary sales of new housing projects.  In Hong Kong, Midland and Centaline are basically the only two brokers that compete in primary residential sales, while over 500 brokers compete in the secondary market ( http://asiaresearch.daiwacm.com/eg/cgi-bin/files/20130304hk_Midland.pdf#page=1). 

    As a result, Midland Holdings’ shareholders have been richly rewarded: book value per share grew from HK$0.35 in 1995 to HK$2.24 in 2012, while HK$2.99 per share in cash dividends was paid out along the way.  Midland Holdings’ profits have been remarkably resilient through good and bad times (i.e. positive operating cash flow since at least the ’95 IPO), and its +817% total return over the last 10 years (June 2003 to June 2013) is higher than all but about 100 of the 1,600 companies listed in Hong Kong.

     

    What is Midland IC&I?

    Midland Holdings branched out into commercial property broking in 1982.  The business segment created for commercial broking was called Midland IC&I, and it remained a profitable but minor P&L contributor to Midland Holdings until the mid 2000’s as you can see from the track record below (note: the post-2007 figures are from Midland IC&I’s annual reports, while the pre-2007 figures are from Midland Holdings’ annual segment breakdowns). 

    (Currency: HK$)

    2012:     revenue = 813m,              EBIT = 207m,      equity = 642m  

    2011:     revenue = 456m,              EBIT = 117m,      equity = 464m

    2010:     revenue = 533m,              EBIT = 157m,      equity = 373m  

    2009:     revenue = 381m,              EBIT = 109m,      equity = 252m

    2008:     revenue = 258m,              EBIT = 1m,           equity = 175m  

    2007:     revenue = 464m,              EBIT = 100m,      equity = 176m

    2006:     revenue = 295m,              EBIT = 65m,         equity = 50m

    2005:     revenue = 279m,              EBIT = 48m,         equity = 42m

    2004:     revenue = 281m,              EBIT = 59m,         equity = not disclosed

    2003:     revenue = 127m,              EBIT = 21m,         equity = not disclosed

    2002:     revenue = 83m,                EBIT = 11m,         equity = not disclosed

    2001:     revenue = 74m,                EBIT = 5m,           equity = not disclosed

    2000:     revenue = 71m,                EBIT = 6m,           equity = not disclosed

    1999:     revenue = 59m,                EBIT = -1m,         equity = not disclosed

    1998:     revenue = 65m,                EBIT = -8m,         equity = not disclosed

    1997:     revenue = 178m,              EBIT = 24m,         equity = not disclosed

    1996:     revenue = 105m,              EBIT = 26m,         equity = not disclosed

    1995:     revenue = 48m,                EBIT = 4m,           equity = not disclosed

     

    The management of Midland Holdings eventually decided that Midland IC&I needed to be spun-out as a separately listed subsidiary in order to boost staff morale, incentives, accountability, etc.  So in 2007 Midland IC&I was injected into a listed shell company that Midland Holdings already controlled. 

    The whole process went like this: in 2005 Midland Holdings paid HK$108 million for 4.3 billion new shares (52% of the then-enlarged share count) of a listed shell company called EVI Education (stock ticker: 8090 HK).  Then in 2007, Midland Holdings sold its entire commercial property division to EVI Education in return for HK$100 million cash a HK$540 million note due June 2012 that would automatically convert into 5.4 billion new shares of EVI Education (or 39% of the 13.7 billion share fully diluted share count).  So the 2005 share placement and 2007 convertible note enabled Midland Holdings to swap their unlisted commercial property division (Midland IC&I) for 71% of a listed company whose name (ticker) they eventually changed from EVI Education (8090) to Midland IC&I (459).  

     

    Midland IC&I’s revenue derives entirely from commissions on commercial property transactions, either sales/purchases or leases.  On sales/purchases, Midland IC&I earns commissions worth 1% of the transaction value from the both the buyer and the seller (i.e. 2% total), minus any discounts/rebates.  On leases, Midland IC&I earns commissions worth half a month’s rent from both the lessor and lessee (i.e. 1 month total), minus any discounts/rebates.

     

     

    What is Special about Midland IC&I?

     

                    Midland IC&I is unique among Hong Kong commercial property brokerages for following reasons:

     

    1)      Strata-title advantage: Midland IC&I leveraged the goodwill of the parent company’s “Midland” brand among mass-market residential property investors (i.e. individuals and small businessmen) to create a commercial property brokerage similarly focused on the “small guy,” strata-title demographic – a demographic that large foreign competitors CBRE, Jones Lang Lasalle, Cushman and Wakefield, Savills, etc. have not traditionally served. 

     

    Granted, giant foreign brokerages like CBRE have an edge over Midland IC&I in big ticket grade A office transactions for institutional tenants in prime, single-landlord buildings.  Since only 20% of Hong Kong’s existing grade A office stock is under strata-title ownership, that formula has worked well so far (see http://www.joneslanglasalleblog.com/APResearch/office-research/kowloon-east-%E2%80%93-a-resilient-strata-titled-office-sales-market#.UeydadJ312A).

     

    But guess what?  Most of Hong Kong’s new office supply coming online is going to be in strata-title and/or small floor-plate offices away from Central, the traditional CBD where office supply hasn’t meaningfully increased in a decade (see page 14 http://asiaresearch.daiwacm.com/eg/cgi-bin/files/HKOfficeMarket_2012Autumn.pdf).  Even giants like CBRE recognize this, and as their recent pre-sales ad for Rykadan Capital Tower (a new strata-title office in Kowloon) suggests https://www.dropbox.com/s/zbj5hutawsg6qfr/CBRE%20strata%20ad.pdf, strata-title sales is where the future action is going to be. 

     

    Yet the marketing of strata-title properties is labor intensive.  Most brokers don’t have the manpower it takes, but Midland IC&I does with over 800 total employees.  I’ve spoken to people at competitors like Savills – not only are they too outmanned to focus on strata-title property (Savills has less than 100 agents in HK), but they even seem look down on strata title properties because of the perception that chopped-up building ownership leads to poor management/maintenance (see the latest Savills presentation here, page 32, where they characterize strata-title property as “unsuitable” https://www.dropbox.com/s/om2vtosjw93rx6i/Savills072013.pdf).  Centaline CIS http://www.centaline-oir.com/?lang=en-us, the commercial property arm of Centaline (Midland’s longtime rival in residential property), appears to be the only other brokerage with the manpower (also +800 employees) to compete with Midland IC&I in strata-title transactions, but since they aren’t a listed company we don’t know much about them.  

     

    2)      Branch network advantage: Midland IC&I’s hidden asset is its ability to rely on a steady stream of client referrals from parent Midland Holdings’ 383 retail branches.  Those branches (most of which are street-level) generate lots of “walk-in” inquiries by individuals and small businessmen – ideal clients for the offices, shops, and industrial properties that Midland IC&I markets.  

     

    Midland IC&I has a small retail network of its own (20 branches) that it pays rent on, but it does not cover any rent/overhead for the 383 retail branches managed by Midland Holdings.*  Midland IC&I does, however, compensate Midland Holdings for any referrals by way of a 50/50 split-commission “cross-referral” agreement (see http://www.hkexnews.hk/listedco/listconews/SEHK/2012/1031/LTN20121031719.pdf).  The details in the October 2012 cross-referral agreement above are very interesting: not only have historical referral commissions been increasing, but forecasted referral commissions are also expected to rise too

     

    Although this internal forecast was done some months before the government’s announcement of unprecedented stamp duties on commercial properties (more on this below), it is interesting to see how bullish Midland IC&I / Midland Holdings were feeling on their cross-referral cooperation.  Indeed, my recent meeting with the CEO of Midland IC&I revealed that in some years up to 20-25% of total revenue can come from these client referrals.

     

    * It’s also important to note that Midland Holdings shrewdly acquired a few dozen of its most prime retail branches decades ago, so the walk-in business generated by those branches is completely free of any rental burden or landlord risk.

     

    3)      Lean, variable cost structure:  Thanks in part to the lack of branch rental expenses (see above), Midland IC&I enjoys an extremely lean and variable cost structure. 

     

    Midland IC&I’s single largest business cost is employee compensation (i.e. salary and bonus).  Fixed salaries for Midland IC&I’s property agents average a paltry HK$6,000-8,000 per month (i.e. assuming a 40 hour work week, this is barely above Hong Kong minimum wage!).  Cash bonuses are entirely based on commission productivity: the typical Midland IC&I agent earns 10-30% of the commission dollars they generate (adjusted for cash flow risks like whether or not the purchaser eventually defaults, etc.).  In addition, underperforming agents (i.e. the bottom 10%) are regularly fired – in Hong Kong you can do this with no red tape, delay, or extra compensation. 

     

    So despite being exposed to cyclical/volatile revenues, by skewing compensation heavily in favor of performance bonuses (i.e. bonus/salary ratios ranged from 1.0 to 3.3 in the last 6 years) Midland IC&I’s been able to keep staff costs as a percentage of revenue in a very tight range: 50-53% from 2007 to 2012.  This is the key reason why Midland IC&I has never lost money on a cash basis since  at least 1995.

     

    Other expenses – commission discounts (rebates), advertising, rental expenses, accounts receivable impairments, depreciation, etc. – are somewhat less variable, but still enough within management control so that they can be scaled down when business is slow.  As a percentage of revenue, these other expenses have ranged from 21-49% between 2007 and 2012.    

     

    4)      Leasing revenue – handy in tough times:  even though sales and purchases grab all the headlines when it comes to Hong Kong property broking, leasing plays an important behind-the-scenes revenue generation role, too.  Regardless of what’s happening in the macro economy, there’s always going to be tenants that need to upgrade/downgrade their commercial space requirements; the leasing commissions those “churners” generate will always be there.  Thus, property brokers that can capture a meaningful share of leasing commissions will have a stable stream of back-up revenue even when the environment for sales/purchases is weak like it is now (more on this below).

     

    According to the CEO of Midland IC&I, leasing revenue accounts for a significant percentage of total revenue.  He declined to give us the exact ratio for 2012, but he hinted that the normalized sales/leasing revenue split over the long-run was roughly 70/30.  He also said that since government intervention in the commercial property market started in February 2013, there have been some months where leasing as a percentage of revenue even approached 90%.

     

    So it’s safe to say that Midland IC&I has a meaningful chunk of leasing revenue to fall back on.  The same can’t be said, however, for parent company Midland Holdings, where leasing as a percentage of revenue was just 5-9% between 2008 and 2012.  This lack of leasing revenue, coupled with the with large retail branch rental expenses, is why profits at Midland Holdings are far less resilient in tough times than at Midland IC&I.  A prime example of this can be seen in the recent profit warnings both companies announced a few weeks ago: while Midland IC&I informed shareholders to expect less profit for the first half of 2013 http://www.hkexnews.hk/listedco/listconews/SEHK/2013/0703/LTN20130703346.pdf, Midland Holdings informed shareholders to expect a loss for the same period http://www.hkexnews.hk/listedco/listconews/SEHK/2013/0703/LTN20130703344.pdf.

     

    5)      Primary sales commissions – where the real money is made: a quick look on page 10 of this 2012 results presentation https://www.dropbox.com/s/wc26fg49zr06v0b/2012%20results%20presentation.pdf reveals a key driver behind Midland Holdings’ success over the last decade: primary residential commission rates (the left-hand chart), which jumped from 1.1% in 1999 to 2.7% in 2012.  Midland Holdings achieved this by convincing developers to outsource more and more of their primary residential marketing burden in exchange for brokerage exclusivity (or semi-exclusivity).** 

     

    Though it’s still early days, Midland IC&I appears to have a good opportunity to establish a similar niche in primary commercial property sales by emphasizing its expertise in strata-title units; some local developers already recognize Midland IC&I for this capability.  The new “t.mark” shopping mall in Tsuen Wan (see top of page 4 https://www.dropbox.com/s/wc26fg49zr06v0b/2012%20results%20presentation.pdf) is a good recent example: thanks to its sway among individual/SME commercial property investors, Midland IC&I was appointed the sole agent on this 233-unit strata-title shopping mall and earned a hefty 4-5% commission on each sale.

     

    According to Midland IC&I’s CEO, exclusive primary transactions like the t.mark are still a small portion of total revenue (he wouldn’t specify the exact breakdown, but I’m guessing it’s no more than 10%).  Still, he agreed that primary strata-sales are a great long-term opportunity: if Midland IC&I can figure out how to do more of these exclusive, fat commission primary deals they should enjoy a P&L boost just like Midland Holdings did when it conquered the primary residential market.

     

    **Why weren’t primary buyers deterred by the tripling of primary commission rates at Midland Holdings?  Probably because such a high percentage of them were new money mainland Chinese (i.e. they accounted for 43% of primary luxury residential purchases as recently as 1Q2012).   Likewise, primary sellers (developers) probably found it easy to accept Midland Holdings’ higher commission rates because of the premium prices their new projects achieved (in Hong Kong, new homes have long-held wide price premiums over equivalent sized older homes), even on a pre-sales basis.

     

     

     

    What is the Double Stamp Duty (DSD)?     

     

    Background:  the Hong Kong government has been very concerned about rising property prices in the city since the global financial crisis.  This concern was initially focused on the residential market, so the administration introduced a series of proposed stamp duties designed to cool down home prices. 

     

    To thwart short-term speculators, the “Special Stamp Duty” or SSD (http://www.ird.gov.hk/eng/faq/#a01) was introduced in 2010: this levied a 15% stamp duty on homes sold within 24-36 months of purchase.  The SSD ultimately failed to cool home prices, so a new “Buyer’s Stamp Duty” or BSD (http://www.ird.gov.hk/eng/faq/#bsd) was introduced in 2012 to thwart foreigners: this levied a 15% stamp duty on buyers without a permanent Hong Kong ID card.  So far, the SSD/BSD have only succeeded in lowering residential transaction volumes, not prices.  

     

    Meanwhile, volumes and prices of non-residential properties – i.e. offices, shops, car parks, etc. anything still exempt from punitive stamp duties – kept rising, especially in late 2012 after the BSD was announced.  When the government noticed this, it decided to intervene in the non-residential property market for the first time ever and introduce the “Double Stamp Duty” or DSD (http://www.ird.gov.hk/eng/faq/#avd).  The DSD basically levies a 1.5%-8.5% upfront stamp duty on both residential and non-residential property transactions (details: http://www.colliers.com/~/media/files/marketresearch/apac/hongkong/white-paper/hk-cooling-mar2013-r.ashx).  Like the SSD and BSD before it, the DSD has only succeeded in lowering non-residential transaction volumes, not prices.

     

    It’s only a legislative proposal, not a law (yet):  The SSD, BSD, and DSD have been very bad news for property brokers in Hong Kong.  As you can see from the Hong Kong Land Registry’s monthly updates http://www.landreg.gov.hk/en/monthly/agt.htm, in June 2013 total sales volume (i.e. the number of agreements for sales/purchases for both residential and non-residential properties) was just 4,616.  This is down from 8,389 in June 2012 and 11,601 in June 2011.  In other words, there were 8 property agents fighting for every 1 transaction last month.  The market lull is literally starving Hong Kong’s property agents (see http://www.thestandard.com.hk/news_detail.asp?we_cat=16&art_id=135399&sid=39938217&con_type=3&d_str=20130711&fc=7), so if transaction volumes don’t improve some brokerages will definitely go bust.  Even Midland Holdings recently warned shareholders that the six months ending June 30 will be loss-making (Midland IC&I warned shareholders to expect significantly less profit, but at least there’s profit!).

     

    Given the effect SSD/BSD/DSD news has already had on the market, one could be forgiven for thinking these stamp duties were already enacted as legislation (many media outlets certainly give that impression).  The truth is these stamp duties ARE STILL JUST LEGISLATIVE PROPOSALS (seehttp://www.legco.gov.hk/yr12-13/english/bc/bc01/general/bc01.htm and  http://www.legco.gov.hk/yr12-13/english/bc/bc05/general/bc05.htm).  

     

    Hong Kong’s Legislative Council (Legco) has the power to veto these bills, and there is a groundswell of smart, influential people like David Webb (webb-site.com), the American Chamber of Commerce, KPMG Tax, etc. that are making the case for a veto on the grounds that the bill 1) makes no policy sense, 2) is riddled with loopholes (i.e. property transacted via shell companies can avoid stamp duties altogether, see http://webb-site.com/articles/dsd2.asp) and 3) is unconstitutional.  28 delegations recently submitted convincing arguments against the DSD, and you can read their position papers here http://www.legco.gov.hk/yr12-13/english/bc/bc05/agenda/bc0520130613.htm.  

     

    Despite popular opinion, Hong Kong’s Legco is not a rubberstamp legislature, and there is definitely discord within their ranks on these stamp duty bills.  Weeks ago I attended a panel discussion breakfast on the Double Stamp Duty hosted by the Canadian Chamber of Commerce http://www.cancham.org/asp/calendar_detail.asp?item=B8SXHC308.  Two of the panelists were Legco members from different political parties – Emily Lau (Chairperson of the Democratic Party) and Tommy Cheung (Liberal Party).  Both openly expressed dissatisfaction with the stamp duty amendment bill in its current form and Emily Lau even quipped something to the effect of “I can guarantee this bill will not pass easily.” 

     

    Even more interestingly, Starry Lee of the “pro-Beijing” DAB party (stands for Democratic Alliance for the Betterment and Progress of Hong Kong) was recently quoted stating her party might vote against the bill http://www.scmp.com/business/article/1277576/opposition-hong-kong-property-stamp-duty-rise-grows-vocal. How significant is that comment?  Hong Kong’s Legco has only 70 seats, of which 43 are “pro-Beijing” (i.e. supposed to do what the Beijing-appointed administration says).  The DAB alone accounts for 13 of those 43 pro-Beijing seats; no other pro-Beijing party holds more seats.  So if this bill is causing dissension even amongst the pro-Beijing legislators, then there must be some chance – however small – that that the bill is eventually amended or vetoed. 

     

    Here’s another way to think about the stamp duty bill: these proposals were the brainchild of the Chief Executive of Hong Kong, Mr. CY Leung, a person who used to be an elite Hong Kong property broker himself (first with Jones Lang Lasalle, then his own company which he ultimately sold to DTZ)!  With that piece of history in mind, it strikes me as silly to bet that CY Leung allows his stamp duties to put all his former property broker colleagues/competitors out of business, especially since the CEOs of the biggest brokerages (i.e. Midland and Centaline) probably still have his personal contact to lobby him directly.  It is not an exaggeration to say that CY Leung owes some of his past success to companies like Midland.  For proof we needn’t look any further than to see who was hired to prepare the property appraisals for Midland’s 1995 IPO (see https://www.dropbox.com/s/65v5y54o0v73lns/MIDLAND%20IPO%20cdv074.pdf page 79 of the PDF file)!

     

                     

    The Big Picture (my two cents):

    All this short-term attention on the double stamp duty has obscured the long-term growth potential for an established brokerage with strata-title expertise like Midland IC&I in office, industrial, and retail property. 

     

    A large chunk of the new office supply that’s coming online in the next several years is slated to be strata-title and/or small floor space units – a huge opportunity right up Midland IC&I’s alley (see https://www.dropbox.com/s/om2vtosjw93rx6i/Savills072013.pdf page 30-33 and http://asiaresearch.daiwacm.com/eg/cgi-bin/files/HKOfficeMarket_2012Autumn.pdf page 14).  But this supply won’t be enough – all analysts agree that there is a severe shortage of office space in Hong Kong, and it’s projected to get worse over the next decade unless the government moves heaven and earth to create a lot more supply than has been planned so far. 

     

    Of the office supply that is yet to be planned but needs to come online in the next decade, a lot of that could come from conversions of old industrial buildings.  The Hong Kong government fortunately realizes how important this is to creating new space, and has exempted these industrial conversion properties from land premium payments – a key incentive to attract industrial re-developers (see video http://www.bloomberg.com/video/hk-s-industrial-properties-lure-new-investors-Pxq0A8ezTayVLSJC2tMTAg.html).   According to Colliers http://www.colliers.com/en-gb/hongkong/about/media/2013-06-20-kowloon-pc, even though 88% of the 1,500 industrial buildings in Hong Kong are eligible to be converted into modern commercial usage, only 6% of these buildings have made an application to convert so far.  So industrial redevelopment is still an enormous opportunity, and since most industrial buildings are strata-owned by individuals and small local companies to begin with, there’s a very big role to play for Midland IC&I here too.

     

    Thanks to the introduction of the Individual Visit Scheme http://www.tourism.gov.hk/english/visitors/visitors_ind.html in 2003, millions of mainland Chinese tourist shoppers (i.e. 3-4 million per month) that don’t trust product quality back home have sent Hong Kong retail sales, retail rents, and retail capital values sky-rocketing.  Tiny street-front shops in once quiet neighborhoods are suddenly receiving huge foot traffic and getting sold for hundreds of millions of Hong Kong dollars.  International brands that never considered selling in Hong Kong before like Top Shop, Victoria’s Secret, etc. have opened flagship stores in the last year alone.  Unless mainland Chinese consumption taxes go to zero and product selection/quality improves a lot, then Hong Kong’s role as China’s duty-free mall should not be threatened too much (after all, 75% of the 1.34 billion people in mainland China have yet to be approved to visit Hong Kong under the Individual Visit Scheme!).  This China-driven retail story is a huge long-term brokerage opportunity for Midland IC&I, and the CEO mentioned they’ve been busy building out their retail team to compete more effectively, especially in primary strata-sales (i.e. the t.Mark mall in Tsuen Wan).

                   

    None of the above long-term growth opportunities are going to disappear from Midland IC&I’s horizon just because the government wants to charge double stamp duty for a little while.  If anything, the double stamp duty has done Midland IC&I a huge favor so far by weakening its competitors, few of which have the variable cost structure and cash hoard to survive a prolonged slump in transaction volumes. 

     

    Will Midland IC&I actually capitalize on all these opportunities? Only time will tell, but Midland IC&I’s current valuation – below book, 1x liquidation value, etc. – is not much to pay to find out.

     

     

     

    Risks/concerns:

    No dividends (yet): The biggest problem I have with Midland IC&I is that it has never paid a cash dividend.  This is possibly because Midland IC&I was until very recently a small spin-off company still in operating in “start-up” mode, so formulating a dividend policy was not a priority.  But that in itself is strange because Midland IC&I’s parent company, Midland Holdings, has one of the most impressive dividend track records in Hong Kong over the last two decades.   Midland IC&I has achieved high ROEs in spite of its ballooning cash pile, but that can’t continue indefinitely.

     

    Something will have to be done Midland IC&I’s cash at some point.  It could be spent on M&A, but Midland IC&I’s CEO told me he’s personally not a fan of acquisitions in the brokerage industry and would rather hire talented people away from rivals.  The other alternative – that the cash eventually gets up-streamed to Midland Holdings – sounds exciting.  But this could be done various ways, like via a cash dividend (great for Midland IC&I shareholders), or via something underhanded like a loan to related companies (bad for Midland IC&I shareholders).  Either way, there is definitely a need for Midland IC&I’s cash at the Midland Holdings (parent) level because A) its residential brokerage lost money in the first half and B) generous dividend payments have depleted the parent-level cash balance in recent years.

     

    In my discussions with Midland IC&I and Midland Holdings, I got the impression that they were fully aware of this cash pile and that their goal is to eventually do something sensible.  From what I can tell Midland Holdings has not done very much to engender mistrust; it has certainly created great wealth for its shareholders over the decades. The only connected transactions you can find at Midland Holdings going back to 1999 are deals where the CEO Freddie Wong hired Midland Holdings to broker properties he owned personally (he paid market price commissions on these deals, and never sold/bought anything into/out of the listed company).

     

     

     

     

    I do not hold a position of employment, directorship, or consultancy with the issuer.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

    Catalysts: surprise dividend payment, privatization (there have been change-of-control rumors at the parent level in the past), earnings growth via primary market sales
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