Description

Wharf REIC (Short)

Ticker: 1997 HK

• TEV Walk
  • Stock Price: HK$44.00
  • Market Cap: HK$134bn (US$17bn)
  • Net Debt: HK$36bn (2.7x leverage)
  • NCI: HK$6bn
  • Enterprise Value: HK$176bn (US$23bn)
• 3-Mo. ADV: HK$164mm (US$21mm)

Current Valuation

• 13.5x Cons 2020 EBITDA
• 7.3% Cons 2020 Levered FCF Yield

Base Case Price Target: HK$36 (-19% downside), assuming the political unrest resolves quickly and further downside if it doesn’t

Summary

We think the current political unrest in Hong Kong will have lingering impacts on the local economy, and have been actively looking for shorts to express this view – our favorite idea is Wharf REIC, a landlord primarily tied to luxury retail malls. We also discuss our second favorite idea, Link REIT (823 HK) below. Our Wharf base case of -19% downside assumes a prompt resolution to the unrest (coming ~1-2 months), with further downside to the extent the situation continues and/or China uses military force – thus this is a fundamental and not macro bet from here with a put option on the macro, which we think is becoming increasingly difficult to resolve.

For context on the Hong Kong retail industry, ~30-40% of retail sales and ~60-70% of luxury retail sales are driven by tourists. In 2018, Chinese tourists accounted for ~80% of all visitors, making Wharf levered to Hong Kong tourism, and more specifically to Chinese visitors.

As a result of the unrest, visitors and retail sales have been in sharp decline (down -44% and -24% y/y in October, respectively - will be worse in November) and the economy is now in a recession, which we think will translate into increasing vacancy and reduced rents for Wharf’s tenants. The street models EBITDA +2% y/y in 2H19, and ~flat in 2020 – the Company is already at maximum occupancy (disclosed 96% retail, 97% office), not expanding square footage, and at peak/unsustainable rent levels, so there asymmetric downside to estimates. In our base case (again, unrest resolved quickly), we think 2020 estimates are ~20% too high. Some of this downside could spill into 2021 depending on the pace of contract renegotiations, but for valuation we assume it is all occurs in 2020.

Business Description

• Wharf REIC is a real estate investment company (landlord, not developer) with 99% of revenue derived from Hong Kong
• Revenue split: ~65% retail, ~25% office, and ~10% hotels. ~15% of retail, or ~10% of total revenue, is a formulaic “turnover rent” which takes a cut of retail tenants’ sales above certain thresholds
• The Company generates substantially all of its revenue from two mixed use properties, with ~80% coming from Harbour City and ~20% from Times Square. These are two premium malls with your usual luxury tenants (Gucci, Fendi, Tiffany’s, etc.) and some office space/hotels

Historical Context

Wharf isn’t growing square footage, and it is at maximum occupancy, making this an idiosyncratic bet on the rents they charge, plus potential for decreases in occupancy. To understand our bearish view on rents, it’s important to understand the historical context - because Wharf has historically disclosed tenant retail sales, we have good insight into their tenants’ sales vs. their own retail rental income.

Since 2010, Wharf’s retail rental revenue is up ~140% (+12% CAGR, from increasing rents) while its tenant sales are up ~65% (+6% CAGR). As a result, Wharf’s retail rent has gone from ~14% of tenants’ sales to ~22% today, eating up ~8pts of margin for their tenants. While these charts focus just on the two main shopping malls, office rental rates (another 25% of revenue) have seen similar increasing rental trends.

Why We Are Bearish Rents?

We break it down into two buckets: 1) what was the short case before the protests; and 2) why do the protests make it so much worse.

As our chart earlier depicted, Wharf’s mall tenants have seen solid +6% annual retail sales growth since 2010, largely as a result of steadily increasing tourist traffic, which is driven almost entirely by Chinese tourists. As you can see in the chart below, 2010-2014 saw dramatic growth in visitor arrivals that have largely leveled off thereafter.

Correspondingly, Chinese luxury spending overseas has been growing at a healthy +9% CAGR from 2011-2018. Going forward, we agree with Morgan Stanley that the rate of overseas spending growth will decelerate, in particular to Hong Kong (for more context, read the Morgan Stanley note from Nov 19, 2019, “Chinese Luxury Consumption - Reshoring Disruption”). This is driven by:

1. Increasing availability of luxury goods within mainland China
2. Decreasing price premium of luxury goods within mainland China vs. ex-China
3. Eventual shift from malls to e-commerce which has lagged the US

Morgan Stanley, “Chinese Luxury Consumption - Reshoring Disruption” (Nov 19, 2019)

In fact, Morgan Stanley expects Chinese tourists to Hong Kong, Macau and Taiwan to decline at a -1% CAGR from 2018-2025. Putting it together, we would expect to see a material deceleration in Wharf’s tenants sales (even before the protests), with Wharf having little to no ability to raise already peak rents.

Which brings us to why things get so much worse with the protests – unsurprisingly, violent protests and clashes with the police have not been good for tourism or retail spending.

The protests started ramping in the middle of 2019 and Wharf reports semi-annually (latest through 6/30/19), so we have yet to see any financial impact of the protests in reported results. Thus far we have two data points:

1. Wharf announced that its tenants’ 3Q19 sales declined -35% and -30% y/y at Harbour City and at Times Square, respectively. This compares to 3Q19 Hong Kong retail sales of -17% – given Wharf’s tenants’ exposure to high end retail, there is increased volatility
2. News reports on 12/12 that Wharf was cutting tenant rents by ~15-20% for some tenants for six months (https://bit.ly/2E8lGVg)

As in any retail business, decrementals are very high for Wharf’s tenants (gross margins call it ~60%, but EBITDA margins in teens) and believe that a 30-35% decrease in sales makes stores unprofitable.

We believe that there will continue to be pressure on both office and retail rents, as well as hotel RevPAR and profitability.

How We Get to -20% Downside to Estimates:

Mechanically, Wharf’s retail rent contracts are structured as the higher of a percentage of tenants’ sales and a minimum base rent. Approximately 12% of total retail revenue is that turnover rent in excess of base rent. In our base case, we assume turnover rent goes to zero, base rents get cut -5% and occupancy increases 5%, results in a net -21% decline in retail rental income (effectively going back to 2016 levels). We view retail sales as being ~15% fundamentally lowered (we assume a rebound vs. ~30-35% recent declines), and a ~20% decline in rents would still result in an illustrative ~25% reduction in retailers EBITDA.

For office, we assume a -10% cut based on rent concessions and no change to occupancy. For hotel, we assume -10% occupancy and -10% rates at a 50% incremental margin.

But Isn’t This Already Priced In?

Short answer, no despite the stock being down -18% since May 31st.

Cons 2020 EBITDA has only been revised -7% since mid-2019, and still call for ~flat EBITDA y/y. In speaking with analysts, we didn’t think there was much pushback that this is an overly optimistic outcome. While we are -20% below current street estimates, we are -27% below pre-revision EBITDA.

We also think a slightly lower multiple vs. pre-protests is warranted given a fundamentally worse outlook for the economy and tourism - this stock used to be viewed as a +MSD price compounder.

We arrive at our HK$36 (-19%) price target based on a 14x EBITDA multiple / 7.3% FCF yield (vs. pre-protest ~15-16x / ~7%).

How Bad Can Things Get In A Downside Scenario?

In our downside scenario, where protests continue and/or Wharf’s tenant sales are structurally -35% lower (which is where they were in 3Q19 before protests escalated in November), we think there is -50% downside to cons 2020 EBITDA.

We assume a -50% reduction in retail rents, -20% in office rents, -30% hotel decline and -10% in other (vs. base case -20%, -10%, -20% and flat, respectively). This might sound draconian, but we’d point out that: 1) even in this scenario, retailers would see a -55% decline in EBITDA vs. pre-protest; and 2) in 2011, Wharf’s retail revenue was -50% lower and its tenant sales were only -22% lower vs. 2018.

On these numbers and still using our 14x EBITDA multiple, the stock would be worth HK$18 (-58% downside).

Link REIT (823 HK)

We’ll keep this short, but this is a slightly different play of a higher multiple / more “defensive” Hong Kong landlord.

Description:

• Geographic mix: 87% Hong Kong, 13% mainland China
• Hong Kong mix: 28% food & bev, 21% supermarkets, 15% markets/food stalls (collectively 64% food related), 19% parking, 17% other (mostly office)
• Viewed as largely stable as it’s not tied to tourism, but rather domestic purchasers of staple food and beverages

The thesis on Link is that this company is similarly operating at peak rents, near zero occupancy, and while their tenants won’t see a -35% decline in sales, a small decline will have a similar impact on their tenants’ profitability. Their tenants are largely grocers and other very low (single digit) margin retailers who are much more sensitive to topline changes. Over the past five years, Link has raised rents at a +10% CAGR vs. their tenants’ sales growing +6% – rent as a percent of tenant sales is up +320bps over this time period, which for a single digit margin business is a problem.

So while their tenants sales may be more resilient, they are still declining (grocery retail sales have recently ticked negative). This is also impacting tenant profitability, such as Dairy Farm International (DFI SP) which is the largest grocer and personal care retailer in Hong Kong (Wellcome and Manning brands - think Krogers and Duane Reade). Per Dairy Farm’s 3Q trading update, “In Health and Beauty, Mannings’ sales and profits have been significantly impacted by the ongoing social unrest in Hong Kong”. Even before the unrest they were talking publicly about cost pressures, in particular rent, negatively impacting the business in Hong Kong.

From a valuation perspective, the stock is trading at ~24x CY20 EBITDA and at a 3.5% dividend/FCF yield. The stock is -14% since May 31st, but we still see ~15-20% downside based on ~5% lower rents and downside to the multiple to reflect peak earnings that shouldn’t grow over the next few years. Some analysts on this stock look at the dividend yield spread to a US 10 year bond - while it’s widened since the protests, this an all-time low spread and the stock is not trading much wider than its historical average spread to the 10 year.

There is also a technical angle, in that the Company has been buying back stock (representing ~15% of ADV) which should go away in the next 1-2 months.

Despite being viewed as defensive, even Link has recently talked about “a tough 2H FY20 after difficult retail trading in Oct/Nov.” (BAML note dated Dec 6, 2019, “Key takeaways from HK Property Chairman/Board Day”).

Catalyst

Hong Kong protests and corresponding responses from police/China

Monthly Hong Kong retail sales data

Fortune REIT (778 HK) reports earnings on 1/27/20 (Bberg forecast)

Wharf earnings in March and updates on tenant retail sales

Sellside notes/estimate revisions - they have been notably quiet/slow to respond