Investment Moats

In terms of investments, CK Hutchison (0001.HK) will probably go down as one of my poorer investments.

I got it at $85.90, $87.65, $81.25, $80.60, $82.90, $76.40, $67.90, $55.45. Based on cost, this is one of my largest position. It may go down as one of my biggest mistakes.

CK Hutchison or CKH for short is the listed flagship company of Li Kar Shing. In 2018, he step down from the company, handing the reins over to his eldest son Victor Li.

Victor Li manages CKH together with the best-paid employee in Hong Kong Canning Fok and Frank SIXT.

CKH this week together with their sister companies CKI, CKA, and Power Assets announced their full-year results.

In terms of key metrics this is how it lines up:

1. Share price: HK$49.60
2. Total outstanding shares: 3.8 billion
3. Total market capitalization: HK$188.5 billion
4. Enterprise Value: HK$395.5 billion
5. Net earnings attributable to shareholders: HK$39.9 billion (2018: HK$39 billion)
6. Free cash flow: HK$35.7 billion (2018: HK$24.7 billion)
7. Earnings Yield: 21%
8. FCF Yield: 18.9%
9. Dividend per Share: HK$3.17 (2018: HK$3.17)
10. Prevailing dividend yield: 6.39%
11. Dividend Payout Ratio: 30%
12. Net Debt to Asset: 19.3%
13. EV/EBITDA: 3.53 times
14. Price / Equity (net of non-controlling interests): 0.40 times.

Why a Post on CKH Matters

On paper, you do not wish to hear me talk about one of possibly my big investment failures. But I thought the results are applicable in the context of what we are going through today.

CKH operations happens to be global:

1. Ports in China, Hong Kong, Belgium, Germany, the Netherlands, UK, Spain, Poland, Sweden, Malaysia, Indonesia, South Korea, Thailand, Pakistan, Thailand, Australia, Egypt, Oman, UAE
2. Retail Beauty & Health stores through AS Watson, ParknShop, Rossman, Drogas in Albania, Belgium, Czech, Germany, HK, Hungary, Indonesia, Ireland, Latvia, Macau, Malaysia, the Netherlands, Poland, Russia, Singapore, Taiwan, Thailand, UK, Vietnam
3. Infrastructure through CKI in Australia, Canada, Germany, Hong Kong, Mainland China, The Netherlands, New Zealand, UK, Portugal.
4. Energy in Canada through Husky Oil
5. Telecommunications in the UK, Italy, Sweden, Denmark, Austria, Ireland, CKH Networks, Indonesia,

2019 is a pretty challenging year by all standards. Being listed in Hong Kong, investors were concern about the impact of Hong Kong Riots on results. Since they have enough assets in Europe, a region which many believe is declining, they were concern about how Brexit impacts them. The declining Euro and GBP is a concern as well. As they are tapped into so many areas of world trade, investors were concerned about how the trade war between the United States vs China and Europe will impact them.

In recent times, it is Covid-19 and the plunge in oil prices.

There is definitely no escape for CKH. They tried to pillage the world. Now the world will royally fxxk them.

In the results update, we can learn more about how well they navigate these challenging times and how Covid-19 and the oil crisis have been for them.

Here we go.

Port Business

1. Europe was down due to some accounting
2. Despite how the results look, Europe have been doing better than last year’s performance
3. Results were boosted by the sale of Chengdu port

Covid-19 port update:

1. Up till 12 Mar 2020, throughput drops 7%
2. What they lost up till now are lost in inventory, which Canning do not think is high class
3. Their port business is used by everyone
4. Canning thinks that at the end of 2020, the port results would be similar to 2019, perhaps a difference of single-digit
5. They are less worried about the port because they believe that they are in the right locations

Retail

1. Loyalty base of 138 million is the largest in the world
2. Loyalty members in China now reach 65 million, with member sales participation high at 80%, reflecting the high degree of loyalty from the members.
3. EBITDA has increased 4% on reported rates and 8% in local currencies. And it reached $16.9 billion, with about 48% coming from Europe and 52% coming from Asia
4. Health business accounts for 92% of retail EBITDA
5. EBITDA growth in all regions:
   1. China: 3%
   2. Asia: 7%
   3. Western Europe: 6%
6. EBITDA Margins: Health and Beauty China managed to maintain very a high EBITDA margin at 18%, contributed positively to the combined overall Health and Beauty EBITDA margin of 11%
7. Capex will go up $1 to $2 billion from $28 billion

How Covid-19 Affected China

Since China was the first country to get hit, and CKH has a retail presence in Asia, here is the update during this period:

1. The shut down has a significant impact on business
2. In Feb 2020, 64% of the 2,500 of the stores are closed
   1. Foot traffic drop 90%
   2. Sales dropped 80%
3. In Mar 2020, since yesterday (20^th Mar), only 4% of the stores are closed.
   1. Foot traffic improved from 90% down to 50% down.
   2. Instead of 80% sales down, its 25% down and improving on a daily basis
4. Sales drop is less than the traffic drop is due to investments in the past few years in technology
   1. MyStore program: Use WeChat enterprise app to connect 22,000 beauty advisers to regular customers, communicate, recommend and make sales
   2. Click & Deliver option: Pick from the nearest stores, deliver in 60 minutes. In this times, although Click & Collect is not working, Click & Deliver was able to effectively replace it
   3. Their online sales have increased 80%
5. “So about how does it affect our operation, I think Dominic has talked about in the Mainland. And then actually, it affected us. You just imagine, we are going without 1 months operation, 90% of our shops are closed. And 60% of our shops is closed and 90% of our sales gone, so everybody stay home. But actually, during those time, we managed to — our staff to manage to keep the customer and engage by doing a lot of retailer, sending them styles to how to do make up and how to do this, how to make the skin better because they are quite bored in China staying at the home.” – Canning
6. “People were quite bored. And — so that you see the result that when the shop starts open, although only 50% footfall, and then our sales reduction and footfall, our sales actually only have a 25% reduction. So that you can see and I hope that this — we are emphasizing on this we start post coronavirus in China. And hopefully, we can gain back that month, that 1.5 months, I would say, February and January is not easy” – Canning

How Covid-19 Affected Europe

If that is not enough for CKH, the epicenter now has shifted to Europe. Here is what Canning and Kai Ming has to say about the business in Europe:

“In Europe, actually, we see the other way around. And in terms of Watson, and you see that in our main market in Europe is U.K., Germany, Netherlands and Poland.

And none of this market is being closed down yet. And then actually, we are a drug store, and we are priority and people in need of us. So that actually, we have seen double-digit growth sales in the first 3 months, in the last few weeks, actually.”

“But the fact that our main business in, say, U.K., Netherlands, Germany, they are classified as essential business by the government. In fact, we’ve got government confirmation in The Netherlands that even if they have a mass store closure, our stores has to stay open.

The government ask us to stay open because we sell a lot of OTC drugs, vitamins.

Let me give you some concrete numbers. Say, for the first 2 weeks in March, our Netherlands, comp growth, 28% increase. In Poland, 23%. Germany, 20%.

This is comp growth, right? So actual growth is maybe even be higher. U.K. for Superdrug 14%. So all these are big numbers, that, I must say, will help the bottom line in these difficult times when the business is under pressure elsewhere.”

– Canning Fok

On Merano in France, which is accounted under CKH Main Office:

You will say that France total knockdown. They are not specialty; all the shops need to be closed.

But however, what is happening, that France is a very fair government and then they actually — they will pay 70% of our staff costs. And also, we have stopped paying rent for the next quarter. And then what we expect, we will continue to renegotiate all the rents because the shops are not open, why should we pay? So that actually, if you look at the profile of our business. And then we are not so profitable until the end of the year. 

– Canning Fok

Infrastructure

Not much of the infrastructure update caught my attention. CKI provides CKH with a recurring dividend income. They have been raising their dividend income for almost the past 20 years.

This year, they also slightly raised it.

However, the business is filled with challenges because GBP and AUD have depreciated a lot. The utility business in the UK is also facing greater risk that future regulated rates will come down.

Energy – Husky Oil

Husky Oil is one acquisition done by Victor Li a long time ago that is damn challenging.

Here is what they have to say about their results and how this oil crisis is affecting them:

1. Their production is only 290,000 barrels a day
2. In 2019, they suffer a net loss of CAD 1.37 billion, attributable is $3.1 billion HKD. This is a very significant loss in their opinion
3. Husky is one of the main reason CKH couldn’t report a stronger overall set of earnings
4. Fortunately, dividend income from Husky to CKH in 2019 is higher than in 2018

On Low Oil Prices

1. Today oil price is $25-$30. Husky oil breakeven is $38.50.
2. Every $1 below this the effect on Husky Energy is CAD 51 million
3. Multiply by 13.5 and the effect is almost $700 million
4. They have 20 million barrels of oil in their pipeline valued at $49. If they mark down this inventory, it will be an additional $416 million loss
5. If $25 persist, Husky will suffer $1.1 billion in losses
6. The share to CKH is CAD 440 million or HKD 2.3 billion
7. The free cash flow impact on Husky is CAD 1 billion negative free cash flow. This is net of CAD 1.8 billion of assumed CAPEX.
8. They should be looking at some cut back in CAPEX and operating expenses.
9. “We have quite a long meeting with the management of Husky. Actually one of the exercises for them to go back home and to do the report back to the Board is to see how much of that 1.8 billion (CAPEX) can be further reduced. So okay. So that what we are trying to do is to have as little negative capital for Husky Oil — Husky Energy for 2020 as possible.” – Canning
10. This is not a forecast but mathematical calculation
11. Financially Husky is an investment-grade issuer
12. They believe they are liquid-based on cash and undrawn bank facilities
13. No debt maturing before 2022. Loan covenant is to maintain debt to capital less than 65%. Currently, it is less than 27%.
14. They see the biggest risk to CKH as not getting any dividend income from Husky. At risk is CAD 200 million or 1 billion HKD

Telecommunications

The telecom segment is a challenging segment all over the world. Incumbents are facing some really strong competition from cheap MVNO operators. On top of this, they would still need to invest in 5G CAPEX.

Here is what they say about the results.

1. Total revenue came up to $87 billion, up by 12% and 17% in local currency
2. The main increase was due to their purchase of 50% Wind Tre in Italy which they did not own. Last year, contribution was only 3 months.
3. UK: Stagnant year. Total margin not growing. They been trying to upgrade their network for 3 years but is not complete. So they replace the CDO with someone they think that they can do the job.
4. Sweden: 4% drop in revenue and margin. Last year they are still taking VAT as income and this year they did not. Margins are actually higher.
   1. “So as Denmark. And Austria, the EBITDA is 1% less than last year. I think they better do well. I hope they listen to me here because I just put $90 million to allow them to buy the fixed-line MVNO, so they promised me that I will see the reward this year. And Ireland, as you say, they have been — I told them that I don’t like spring, the project spring they have. And then they recovered from that, and — so that they are doing very well. You saw it in the figure.” – To be honest I have no idea what Canning is talking about.
5. They plan to separate out the CKH cell towers into a separate company
   1. There will be 28,500 cell towers
   2. Attributable EBITDA to CKH is EUR 300 million ($2.5 billion HKD)
   3. Public Listing is an option but not a preferred option at this point.
   4. There is potential merger and acquisition activity that could be beneficial.
   5. They have optionality to explore further now that they have set up this structure

Performance of Wind Tre in Italy

In July 2018, CKH agreed to pay EUR 2.45 billion for the 50% stake in Italy telecom Wind Tre that they do not have from Amsterdam based Veon. Wind Tre was form in a 2016 merger between the merger of VimpelCom’s Wind Telecomunicazioni and CKH’s 3 Italia.

Going into dying Italy looks like another questionable move for CKH. In 2019, 50% of Wind Tre’s EBITDA is about EUR 1.05 billion and 50% of EBIT is EUR 678 million.

This means they paid 2.3 times EBITDA and 3.6 times EBIT for this 50% stake. That looks reasonably cheap to me.

1. On a 100% basis, Wind Tre EBITDA shows a 5% improvement.
2. Gross margin dropped 3% (too competitive).
3. Customer acquisition costs (CAC) shrunk massively from 142 million to 82 million.
   1. “As I always say, Wind Tre is just like one either animal plus 1-legged man with the other is 1-legged woman. If these 2 combine together, actually, we have 3 eyes and 3 legs and look better and run faster. So as a result of this, not only that we are able — of this consolidation, we are now — we are able to generate much more financial muscle, including reducing the interest expense from 2.75% to 1%, less than 1%, number one.”
4. They reduce interest expense from 2.75% to less than 1% 
5. They try to build the best network in Italy
   1. “If you look at during the corona crisis, our network was so good. And one of our competitors actually collapsed, and we are still okay. So that I think our network is today is the best network, and you can see that give us a lot of leverage going into the future.” – Canning
6. Network consolidation is completed in Q4 last year
7. “I don’t think we would hesitate to say that we currently have the most robust and highest capacity network in Italy. And one of the fascinating things about it is because it’s so new, it is the largest 5G handset-ready network in Italy using something called dynamic spectrum sharing on the 1800-megahertz frequency. So any 5G handset can handle 1800, right, will get 5G performance on the network right away. There’ll be further 5G construction, right, which will be aimed at specific business opportunities and aimed at continuing to expand the overall network speeds and the overall network capacity. That’s over the course of the next few years. But nobody who buys a 5G handset is going to be disappointed in Italy by comparison to using anybody else’s network.” – Canning

Covid-19 Impact on Telecommunications

1. Growth sales have reduced a little
2. Churning have reduced a whole lot
3. Data usage have grown a whole lot
4. Every one of the business is on budget or more than budget in the first 2 months
5. “I think the special attention is to the safety of the staff and also how to run the company remotely, which we are prepared, and also the more important is the network. And then in Italy, we are doing very well in anywhere. In — our network is quite good.”
6. Ireland: Growth actually went up
7. “Even in Hong Kong, you see the same effect. People talk more. People would stay at home, had nothing to do, watching shows, telecom communication is one division we don’t need to really worry.”

Overall Comments on 2020 Covid-19 and Oil Strategy

Here are some of the management’s comments on what they will do:

1. Prioritizing financial strength over investment and growth
2. Put everyone to scrutinizing cash and investment in capital spending
3. Everything go through head office
4. Capex will be dramatically down
5. In all these countries affected by the virus, usually, even if they have a lockdown scenario, would be groceries and drugstores will have to be open. So actually, it’s our duty to open.

On Cash Flow, Dividend Policy and Share Price Weakness

The management gave some opinion about their cash flow going forward:

Cash Flow outlook 2020: Very positive. Earnings currently significantly above budget for the first 2 months.

On their ability to maintain their dividend policy:

Our dividend policy will be in line with our midterm forecasts for our profit. I don’t expect a lot of swings unless very unpredictable things happen. But right now, we’re steady.

With the net debt-to-capital ratio down to below 25%, is this the right time we can expect dividend to be moving in line with earnings? We’re always moving dividends in line with earnings. That’s the general thinking.

Management also address some questions regarding recent share price weaknesses:

Virus times. It’s difficult to look at share prices on a day-to-day basis, all I can say is that Hutch is good value, and we’re going to use — evaluate the opportunities. But right now, we cannot disclose our plans.

Actually, we are working very hard on the cash flow and the possibility of the company. So if you see that in this year, there are many things coming. But again, we are able to produce the kind of earning that we produce.

I think this year, CKH’s aim is to show that even in a shock like the virus, a lot of our business is still very resilient and that we can deliver the cash flow in such hard times. So that will show the quality of our earnings.

Summary

If you are interested, you can read the transcript here.

The most beautiful part of their business is the retail business, which in this climate happens to be the most challenging. My friend says that the port is a dying business. Telecom is a CAPEX and competition intensive business. Husky look like a shit acquisition. The regulated utilities in CKI is challenging as well.

If we did not have Covid-19, I would look at their 2019 results and think… that is not too bad set of a result.

Canning or Victor mention in last year’s result brief that if this trade war affects CKH in one way, they are so well covered that they would benefit in other areas.

CKH has a small conglomerate advantage in that they can grow underlying earnings, EBITDA through acquisition. The power of CKH, CKI, CKA is that they can make join acquisition of quite sizable firms.

They can buy flaw companies and fix them in a few ways:

1. Refinance debts using their much better credit rating. This reduces the cost of debt. See ISTA and Reliance Industry acquisition in CKI and of course Wind Tre in CKH
2. Tap upon their expertise in various segments to improve the company
3. Cross sales and distribution channels

CKH may be a value dividend play. If you look at its business to give you

1. Low payout ratio
2. Decent dividend
3. The whole business not too expensive
4. Very diversified income sources (4-5 segments, various countries, different currencies)

Not sure how many other businesses are there.

But we know value is dead.

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