There are some deals that you have to treat as homework.

Going through some of these deals are both a mental exercise but also whether we are able to identify whether any part of the deal is attractive enough.

Sembcorp Industries(SCI) and Sembcorp Marine (SMM) were halted a few days ago. There were speculations of privatizations and rights issue but yesterday we get a better picture of it.

There are 2 parts to this deal:

1. Sembcorp Marine will issue a renounceable rights issue of 5 rights shares for every 1 existing Sembcorp Marine share at S$0.20. This is not to acquire some assets but to re-capitalize SMM.
   • The proceeds will be mainly used to replace existing debt that was mainly issued by parent Sembcorp Industries
2. After the rights issue, Sembcorp Industries will distribute the 100% Sembcorp Marine shares they own to existing shareholders. Roughly each SCI shareholders would receive between 427 and 491 SMM shares for every 100 SCI shares they owned.
   • If you are a current SCI shareholder, now you own SCI and SMM separately and you can decide what you want to do with it

There are two parts of this deal so let me talk about the rights issue first.

The 5-for-1 rights issue of Sembcorp Marine

The existing balance sheet of SMM looks like this:

• Assets: 8.4 billion
• Cash: 389 million
• Debt: 4.4 billion
• Equity on book: 2.2 billion
• Number of outstanding shares: 2090 million shares
• Last traded share price: $0.85
• Market Capitalization: $1.78 billion

Sembcorp Marine’s debt to asset is at 52%.

This debt to asset is high but not bothering dangerous levels. This rights issue will bring in $2.1 billion in funding.

Management have stated that this $2.1 billion is to replace the debts. One of the main debt is a $1.5 billion loan from Sembcorp Industries to Sembcorp Marine.

Since Sembcorp Industries currently own 61% of Sembcorp Marine, this action effectively turned SCI’s shareholders from bondholders to equity holders (for a short duration of time heh)

This deal… is dilutive to existing shareholders.

SMM is not doing any groundbreaking acquisition and the effect of replacing debt tends to mean that existing profits and cash flows are shared among a bigger pool of shareholders.

SMM shareholders should feel horrendous about this.

SCI will subscribe up to an amount worth S$1.5 billion out of the S$2.1 billion in rights shares.

What about the other 39% minority SMM shareholders?

The trick is that if these 39% SMM shareholders do not subscribe to their rights, Temasek will subscribe to the remaining S$0.6 billion worth of rights.

So if you look at the right side, SMM ownership will change to a mixture of Temasek, SembCorp Industries, and minority public shareholders.

Because it is so dilutive, most likely the minority public shareholders will not subscribe to the rights issue (this is a renounceable rights issue which means you can renounce your right to subscribe by selling your rights when it is listed to others)

So eventually the ownership structure should be 6.5% SMM public shareholders, 23.6% Temasek and 69.9% Sembcorp Indistries.

Note: Temasek does not own any share in SembCorp Marine directly at this point.

If we piece the conversion of SCI’s loan to SMM and the structure of this rights issue, we can see that the deal was structured to plan for the dis-association of SCI from SMM.

How SMM Would Look Like Post-Rights Issue

The debt of SMM will be reduced but equity will increase. There will be dilution of earnings but it seems the new shareholders Temasek is not that concerned.

The rights issue will bring on 10 billion in shares and post-rights issue the number of shares will increase to 12.5 billion.

The rights were issued at nearly 75% discount of last traded price. Massive discount.

The theoractical ex-rights price (TERP for short) after the rights issue will be around $0.31.

SembCorp Industries Distribution of SembCorp Marine Shares Post-Rights Issue

After the rights issue, Sembcorp Industries will pay out the shares they own of SMM to all their shareholders.

You can think of this as SCI giving stock dividends.

Before we go into this, this is how the ownership structure is like:

• Temasek owns 49% of SCI. They do not own SMM.
• SCI owns 61% of SMM.

With this SMM stock distribution, this means Temasek, through SCI, will now own directly 29% of SMM.

If we mesh this together with the ownership structure of SMM, Temasek will now own 23.5% + 29% = 52.5% of SMM.

This makes Temasek effectively the direct parent of Sembcorp Marine.

The slide above was put out by the companies.

There are 2 rows, with the top row if no minorities subscribe to the rights issue and the bottom row if all minorities subscribe.

The placing of no minorities subscribe in the top row seem to indicate that this is the outcome that they are expecting.

In that scenario, Sembcorp Industries ceased to be a shareholder in SMM. Temasek becomes the majority owner as well as existing SCI and SMM shareholders. (Notice that the Temasek ownership % and my 52% is different, obviously, some of my math might be wrong.)

The alternative scenario is that all minorities subscribe and there are no majority shareholders of SMM.

This I think is unlikely the scenario (hence the ultra discounted rights-issue that is so dilutive to force your hand)

A Cleaner SembCorp Industries Emerges

The most appealing part of this deal might be that without the baggage of SMM, SCI might be re-rated better as a utilities and urban development business.

Since SCI owns 61% of SMM, they consolidate SMM’s full income and balance sheet into SCI.

If we backed it out we have a leaner SCI. This SCI has a net debt to asset of 34%. (I am not sure if I have double-counted the $1.5 billion SCI lend to SMM so do be wary of my math here.)

The above slide was extracted from SCI’s full year results.

If we remove the marine business, SCI does not look so bad. The energy business, made up of mainly local and overseas utilities ventures tend to be recurring in nature. The Urban business not so much.

A business like this should be valued based on cash flow. We can use a conservative Price Earnings to value SCI.

But how much is conservative? A well operated utility business such as Cheung Kong Infrastructure (1038) (CKI) is trading at 10 times PE.

I don’t think SCI is as superior as CKI.

If we backed out the marine losses, the net profit could be $450 million. A PE of 8 times would bring the market capitalization to $3.6 billion or $2.00 per share.

However, if you buy SCI today, you get the SMM stock dividend as well. So you have to include that in.

However, how much would the SMM share eventually trade at?

Conservatively, if the rights is priced at $0.20 then maybe that is a conservative price to assume. If you want, you can use $0.15 or $0.10.

If you own a share of SCI this would entitle you to maybe 4.27 shares of SMM:

1. $0.20: $0.85
2. $0.15: $0.64
3. $0.10: $0.43

This sort of bring the intrinsic value of SCI to between $2.43 to $2.85.

Think the share price will shoot up.

As with all things valuation, there are assumptions and I might have make mistakes here and there. So do not treat this as the truth.

Do Like Me on Facebook. I share some tidbits that is not on the blog post there often. You can also choose to subscribe to my content via email below.

I break down my resources according to these topics:

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In 2018, I spotted a telecom operator that has in excess of a 10% free cash flow yield. So I took a look at it.

Till today, I could not increase my conviction in this stock due to the limited information that I could uncover about the business.

It is not a very sexy business and I think in recent years, not many folks would touch it due to the challenges in the industry.

My posture has always been to let the company’s result tell me if I was wrong, or that I was cautiously right. The world is different today, but the share price is not too far off from where I first pick it up

A Brief Introduction to Citic Telecom

Citic Telecom (stock code: 1883) was established in 1997 and listed on the Hong Kong Stock Exchange in 2007.

The company provides a whole assortment of telecommunications service mainly to the people in Macau and coming into Macau.

Citic Telecom owns 99% of Companhia de Telecomunicacoes de Macau, S.A.R.L. (“CTM”). Before 2013, Citic Telecom owns only 20% of CTM. In 2013, Citic Telecom purchase the other 79% of CTM that it does not own from a wholly owned subsidiary of Cable & Wireless Communications and Portugal Telecom.

The purchase consideration was US$1.16 billion or equivalent of HK$9 billion then.

Macau Post, an entity controlled by the Macau Government, owns the remaining 1% equity in CTM.

1. CTM held a 41% market share in the Macau mobile market. This was down from 43% in 2018.
2. CTM held a 42% market share in the Macau 4G market. This was down from 46% in 2018.
3. CTM held a 97% market share in Macau’s broadband services with a broadband penetration rate greater than 91% at end 2019

A substantial shareholder of Citic Telecom is Citic Group. Citic Group, a large state-owned enterprise in China owns 58% of Citic Telecom.

The Macau Telecom Market

Macau boasts a sophisticated, independently regulated communications market. Liberalization has now fully opened the telecoms market.

Demand for telecom services is significantly driven by the millions of visitors that visit Macau every year. 87% of visitors classified as residents of mainland China or Hong Kong.

Macau’s mobile market is very competitive. There are four mobile network operators (CTM, Hutchison 3, SmarTone, and China Telecom Macau) and a mobile virtual network operator (MVNO) offering services.

Mobile penetration is in excess of 200% due to multiple SIM card ownership as well as sales of SIM cards to visitors.

Macau have a population of 650,000.

Citic Telecom’s Business

Like most telecom operators, Citic Telecom’s revenue is derived mainly from

1. Mobile sales and services.  Sale of handsets and providing 4G and in the future 5G mobile services. This is their main bread and butter.
2. Internet services. This would be broadband services.
3. International telecommunications services. Voice services, SMS, and their “DataMall” services.
4. Enterprise solutions. Citic Telecom through its subsidiaries provides info-communications and technology services (ICT). Customers are mainly global MNC. This business spans more than Macau but includes Europe, Russia, China (those countries along the One Belt one road), South East Asia. Services include Cloud computing, VPN services, Datacenter services, systems integration.
5. Fixed-line services. This is the declining phone line business. While they own a monopoly on this, it has been declining and will decline over time.

The unfortunate thing with Citic Telecom is that they would only provide breakdown of their revenues by segment. In this way we have no idea how well each segment is doing.

The Challenges for Telecom to Diversify Away from Traditional Profit Sources

We do know that overwhelmingly the mobile services and internet services enjoy the best EBITDA margins of around 20-30%. The enterprise solutions segment should command around 10 to 15% margins.

The one thing I realize as I read a few annual reports of telecom companies is that they will describe the great potential of their various segments.

However, at the end of the day, majority of what drove profits is the mobile and broadband business.

The rest of the enterprise, advertising, internet content, data center segments often are either still losing money or a small portion relative to the mobile and broadband business.

This is also where telecoms struggle with as they have become more like commoditized utilities. We subscribe to one provider but we are so fickle that when another provider lowers their price, we switch over.

With greater number of players, this will reduce a very high EBITDA margins down. Since the mobile and broadband EBITDA margins are so much higher than the rest of the new segments a telecom operator is trying to develop, telecom operators’ results live and die by the mobile and broadband segment.

However, despite what I mention, the telecom operators have no choice but to explore these new segments.

The main reason is that; they already have the infrastructure. By developing new users around the technology infrastructure, they encourage greater use, and may be able to charge enterprise clients, SME at better rates.

5G brings a lot of promise (and also lots of CAPEX) but at this point, it is just potential.

Citic Telecom’s Segmental Revenue

While Citic Telecom is adding mobile subscribers, revenue did not seem to move much. Fixed line services is on a declined.

The surprise was the boost in international telecommunication service in the past 2 years due to SMS and voice. I wonder whether that will continue.

Mobile Subscriber Growth

While there can be more mobile penetration over time, it does not mean it translate to revenue. This is because ARPU tends to go down over time as well.

Here are some of the latest Citic Telecom subscriber numbers we have:

1. 2019 Postpaid Subscribers: 350,000
2. 2019 Prepaid Subscribers: 796,000
3. 2019 Broadband Subscribers: 193,000

Here is the growth of Macau prepaid sim cards over the past 10 years:

Probably not the most up to date but better than nothing. Citic telecom probably have slightly less than 50% share of this.

The compounded growth is 12% a year.

Here is the growth of Macau mobile subscribers over the past 10 years:

I think I would trust Citic Telecom when they tell me that by 2019 their market share would be 41%.

The compounded growth was 7% a year for the past 10 years.

Given this kind of consistent subscriber growth, and that Citic was able to capture enough market share, it cannot be revenue stay stagnant for so long. The only explanation is that in terms of the operating dynamics, it is unfavourably deflationary.

A2P SMS

What have been driving this have been A2P SMS Business. A2P stands for app to person.

There seem to be an increase in the pace of global expansion of major PRC internet companies and with that a growing demand for authentication SMS from financial institutions.

1. In 2018, SMS revenue grew 38% or 146 mil.
2. In 2019, SMS revenue grew 74% or 287 mil.

International Telecoms have been declining and suddenly this turned around.

Amazing.

If you bank with Bank of China in Singapore, you will know how crazy their 2FA SMS can be. Almost every action generates an SMS.

According to a survey done by Ovum and Tata Communications, SMS is the primary mobile specific service that companies use to communicate with customers.

A2P have been gaining momentum for a few reasons:

1. Consumers prefer their communication to be short and personalized and on their terms
2. SMS open rates are higher and faster than email open rates. 98% of SMS messages are read versus 20% in email
3. Increase two factor authentication

Ovum forecasted that by 2022, revenues from app to person SMS will exceed revenues from person to person SMS. This is despite the traffic from A2P to be half that of P2P SMS.

“Unfortunately for most telcos, P2P SMS has become essentially value-less, since they have had to bundle unlimited SMS into mobile tariffs to remain relevant to their customers, an increasing number of whom use chat apps such as WhatsApp, WeChat and Facebook Messenger.

However, telcos can still charge a per-message termination rate for A2P SMS, which means it remains a more valuable source of revenues, since enterprises still value SMS for its global reach, affordability and mature ecosystem. However, chat apps, which Ovum forecasts will have 3.2bn unique monthly active users (MAUs) by 2020, are also connecting enterprises with consumers via their platforms. Telcos and the wider ecosystem are therefore under pressure to protect their A2P revenues, driving them to upgrade from SMS to Rich Communication Services (RCS),” – Ovum

Enterprise Growth

The growth area is definitely in internet services and enterprise. Part of the boost in Enterprise have been acquisitions:

1. In Oct 2016, they acquired Acclivis Technologies and Solutions Pte Ltd. You might be familiar with it because it used to be a subsidiary of DeClout Limited. It provides comprehensive cloud facilities and owns Pacific Internet in Singapore and Thailand
2. In Feb 2017, they finalized the acquisition of Amsterdam-based Linx Telecommunications. This includes Linx’s 470 KM submarine fiber network in the Baltic Sea, its network operation centers (NOC) in Moscow and Talinn, Estonia. It also includes a data center in Estonia serving Estonia’s largest internet exchange.
3. In 2016, Citic Telecom acquired Citic Telecom Tower (CTT) in the data centre cluster in Kwai Chung, Hong Kong. Their intention was to turn this into a high grade data centre with more than 4000 racks. They completed this in late 2018. In 2019, they sold out all the racks and proceed to expand with 500 more racks. This should be completed this year or next year.  

For the past 4 years, the enterprise segment has grown 15% a year. If we assume that the conservative operating margin of 10% a year, this will add 4.5% a year to Citic Telecom’s profit.

However, if I look at Citic Telecom’s profit growth in the past, I am probably either too optimistic in the segment growth or operating margin, or there were administrative overheads.

Review of Competitors

For some reason Macau has got to be the most opaque telecom market to do research.

Out of the 3 competitors, Hutchison 3, Chine Telecom Macau and Smartone, I can only find the results of Smartone.

For such a small city of 650,000 people, they have 4 telecom operators and one MVNO.

This is one of the reason I was pretty cautious on this investment.

Intense competition has sort of kept Citic telecom on their toes. During the time where I remain invested, telecom operators around the world have been struggling due to competition. For some reason, Citic telecom has remained a bright spot among the telecom operators.

Citic Telecom’s Revenue Growth

Citic Telecom’s revenue have not been great for the past few years since they acquired almost all of CTM’s stake. The most meaningful boost to revenue was from 2017 to 2018.

$1 billion of that came from handset sales, and another large contributor was from… SMS-based services. SMS revenue in that year was up 386 million, which is a 37% increase.

Just when we thought SMS is dead, we did not realize that the demand for greater security have also increase the need for 2FA authentication. One common way is through SMS.

Citic Telecom’s Profit and Cash Flow Trend

Given the revenue profile, it is a little surprising that Citic Telecom’s profit growth has been pretty decent.

For the past 6 years the profit growth averages 5.5% a year. Citic Telecom profit margins have held up pretty OK.

We are not sure what the future may bring, but it is likely the growth will not exceed this range unless 5G surprises me on the upside.

Given how intense competition has been in the telecom space, I would not be surprised if the compounded average growth slows down to 2-3%.

While Citic Telecom’s profit growth looked decent, their free cash flow growth looks much better, especially in 2019.

2019 was boosted by higher depreciation and slightly higher net profit. Free cash flow growth over the past 6 years have been 16% a year.

I should warn readers that my free cash flow is computed by using operating cash flow before working capital. This will give a more consistent free cash flow. However, I am not glossing over working capital.

For the most part, Citic Telecom’s net working capital is quite in control, and I did not detect any signs that it will manifest into a greater issue. (If you would like to learn to differentiate each of the cash flows used in investing, you can read my comprehensive cash flow article here)

I have also listed the dividend paid out each year, relative to net profit. The dividend payout ratio starts off low at 24% and progress upwards closer to 70%.

If you look at the dividend paid out relative to profit or free cash flow, the payout has been rather conservative.

The issue with telecom operators is that they have to sink in greater amount of funds for capital expenditure but they could not earn incremental value from it.

Citic Telecom’s capital expenditure over the years have gone down quite a fair bit. However, Citic Telecom have indicated that once they have the 5G approval they will roll out the deployment of their 5G network in the first half of 2020 (it remains to be seen if Covid-19 will affect this plan).

Macau will be one of the first few cities in the world to have full 5G network technology coverage.

With the roll out in mind, it is likely that the capital expenditure in 2020 could be higher than the average Capex trend of the last few years.

Whatever cash flow that is left over from capital expenditure is mainly channelled to reducing their debts over time. Citic Telecom’s debt to asset have reduced from a less than comfortable 44% to a more comfortable 29%.

The Impact of Hong Kong Protest on Citic Telecom Results

I was also interested to review the full year 2019 results because from the segmental reporting, a large portion of revenue comes from Hong Kong.

The issue is that I am not sure if this was derived by customers in Hong Kong or that it is due to a subsidiary domiciled in Hong Kong.

I have a feeling it is the latter.

In any case, the unrest in the second half of 2019 did not affect Citic Telecom much. This was quite fortunate.

The Potential Impact of Covid-19 on Citic Telecom

Covid-19 is a different challenge altogether. I think I was quite lucky that out of all the stocks I own, I have a fair bit of telecom holdings in 2 of the stocks.

An industry that most investors do not like turn out to be in a better position than a lot of the industries that most investors like.

Telecommunications became very essential now.

However, certain segments of Citic Telecom would be affected by this:

1. A portion of revenue comes from people visiting Macau. With lock-down restrictions, and very, very low tourism numbers, part of mobile revenue will be affected.
2. A part of ICT revenues should come from on-going projects. This may be adversely affect when some projects are put on hold.
3. International telecommunication revenue likely going to be affected as well

Macau depends on tourism. It is likely some of Citic’s main ICT customers are the casino and resort operators.

For this reason, I am not optimistic about their upcoming results.

Some numbers:

1. 2017 Postpaid (exclude Internet of Things and SIMN) ARPU: HK$206
2. 2017 Postpaid (Internet of Things and SIMN) ARPU: HK$30
3. 2017 Prepaid ARPU: HK$11
4. 2019 Postpaid Subscribers: 350,000
5. 2019 Prepaid Subscribers: 796,000
6. 2019 Broadband Subscribers: 193,000

Most likely, the Postpaid revenue is 7 to 8 times that of Prepaid. I think the impact of this is quite controlled. However, I cannot be certain of the aggregate impact.

The graph above shows the 5 year Macau mobile telephone subscriber growth. There was some craze spike from Sep 2019 to Dec 2019 where the number of subscribers went from 2.1 mil to 2.8 mil.

Note that a large amount of these are likely to be pre-paid subscribers.

I suspect that this was due to the unrest in Hong Kong diverting the amount of people there.

In any case, Covid-19 has totally collapse this:

1. 2020 Feb: 2.44 mil
2. 2020 Mar: 2.29 mil

I suspect this drove the spike in A2P revenue. For the next 6 months’ result, Citic Telecom probably will reverse that A2P revenue.

Valuation

For a business with recurring cash flow, earnings yield and free cash flow yield seem to be the better way to evaluate whether Citic Telecom is attractive or not.

EV/EBITDA is another one.

Citic Telecom have 3.65 billion shares outstanding. At a share price of $2.89, this puts Citic Telecom’s market capitalization at $10.5 billion.

With a net debt of $4.9 billion, this puts Citic Telecom’s Enterprise value to be at $15.4 billion. Citic Telecom’s 2019 EBITDA is $2.49 billion.

This gives Citic Telecom an enterprise value of 6.2 times. This is pretty attractive.

With a net profit of $1 billion and a free cash flow of $1.5 billion, this gives Citic Telecom earnings yield of 9.5% and free cash flow yield of 14.3%.

Currently, Citic Telecom have not gone ex-div yet. The share price bakes in a $0.15 dividend. If we backed that out, the market capitalization you are buying Citic Telecom at is $10 billion. Likely the valuation will not differ much.

In any case, the risk to this valuation is that things do not return to normal with social spacing. It will affect the number of people visiting Macau. Of course, Citic Telecom have the potential to offset this by the increase demand in their ICT business.

Based on the latest dividend per share of $0.20, this gives Citic Telecom a dividend yield of 7.3% (if we use the ex-div price of $2.74).

Investing in this climate is tough because there are a lot of uncertainty. If you look at Citic Telecom, the valuation does not look expensive, but they are operating in an area where prolong shut downs will definitely affect the business.

We will have to see how this unfolds.

Do Like Me on Facebook. I share some tidbits that is not on the blog post there often. You can also choose to subscribe to my content via email below.

I break down my resources according to these topics:

1. Building Your Wealth Foundation – If you know and apply these simple financial concepts, your long term wealth should be pretty well managed. Find out what they are
2. Active Investing – For the active stock investors. My deeper thoughts from my stock investing experience
3. Learning about REITs – My Free “Course” on REIT Investing for Beginners and Seasoned Investors
4. Dividend Stock Tracker – Track all the common 4-10% yielding dividend stocks in SG
5. Free Stock Portfolio Tracking Google Sheets that many love
6. Retirement Planning, Financial Independence and Spending down money – My deep dive into how much you need to achieve these, and the different ways you can be financially free
7. Providend – Where I work doing research. Fee-Only Advisory. No Commissions. Financial Independence Advisers and Retirement Specialists. No charge for the first meeting to understand how it works

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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Wharf Real Estate Investment Company’s (REIC) interim results was not too bad.

I first wrote about Wharf REIC here. If you are not familiar with it, you might want to get a short overview of it through that article.

Operating profit showed an improvement over last year. The profit attributable to shareholders was lower due to a reduction in fair value increase of the investment properties.

That portion should be OK. We should look upon the recurrent earnings or cash flow aspect of the business.

The majority of the revenue for Wharf REIC (1997) is from its retail and commercial office rental income. In the past, since the cash flow is so recurring, we would annualized the earnings or cash flow. We could then assume a no growth scenario and see the relative valuation of Wharf REIC versus its peers in the same industry.

If we take the operating profit ($6.7 bil) – Income Tax ($1 bil) – Non-Controlling Interests ($0.08) – Financing cost of ($0.460) we arrive at a recurring net income of $5.16 bil. Annualized we get $10.32 bil.

Wharf REIC currently has 3 bil outstanding shares, thus the recurring EPS is $3.44. Wharf REIC current trades at a price of HK$45.20.

This gives Wharf REIC an earnings yield of 7.6%. Wharf REIC have a dividend policy of paying out 65% of its earnings income. This brings its dividend yield closer to 4.9%.

How should we look at the valuation?

Wharf REIC is results is driven by 2 retail malls, Harbour City and Times Square. To give you an extend of the influence of these 2 malls, together, they account for 10% of Hong Kong’s retail sales including wet market, motor vehicles but exclude F&B. Harbour City is 4 times one of our biggest mall VivoCity.

Wharf REIC’s net debt to asset is 13%. This means the leverage factor is low.

Unlike a REIT, Wharf REIC pays taxes. Name me a few retail mall REITs of this quality that trades at a recurring earnings yield of 7.6%.

I doubt you can find many.

And how many gives a historical dividend yield of 4.9%, backed by high quality assets on 65% recurring payout?

Harbour City (HC) and Times Square’s (TS) occupancy cost is rather manageable. We know it is higher versus Capitaland Mall and Frasers Centerpoint Trusts.

Wharf REIC’s dividend per share have observed to be consistently growing. It’s occupancy since 2009 have been consistently high. The revenue trend have also been consistent.

When a company do not pay out all their free cash flow as dividends, and they have a good recurring business model, they can show a rising dividend per share trend.

Certain tenants of Capitaland Mall, a Retail REIT in Singapore is on a percentage of turnover rental revenue model. This means that part of the rent is determined by how well the sales is. It gives the mall operator an incentive to do their best to make sure they also deliver in bringing greater footfalls to the tenant.

Upscale malls like Harbour City and Times Square should take a certain part of their rental revenue from percentage of sales. That would explain the good revenue trend.

Here are the average passing rent per square foot per month:

1. Harbour City: $508
2. Times Square: $290
3. Plaza Hollywood: $102

The disparity is huge.

Here are the respective retail sales for the past 6 months:

1. Harbour City: $18.5 bil
2. Times Square: $4.4 bil
3. Plaza Hollywood: $1.2 bil

We are investors who are seeking to make money. Whatever happen in the future is what we are concerned about. To find out whether the cash flow is growing and recurring, we look at the past to find results.

And since the intrinsic value of a stock is based upon the aggregate of future cash flow discounted to present value, what if all these riots and protests fundamentally alters Hong Kong?

Wharf REIC highlighted how the 3 mall revenue changes during the recent 2 downturn. In 2008, we observe a -19% shift in rental revenue.

The webcast or the webcast transcripts were not out yet, but in an article on the South China Morning Post (SCMP), Stephen Ng, the chairman & managing director of Wharf REIC and Doreen Lee, vice-chariman and executive director of Wharf REIC have these to say:

1. “This time, it is like a perfect storm. External factors and internal factors are all erupting at the same time,”
2. “In July and August, Hong Kong’s overall retail sales are not [expected to be] very optimistic. We will be affected,”
3. “Overall, tenants’ businesses [have become] more difficult.”
4. “We all know Hong Kong’s retail and catering industries are [facing difficulties], particularly in shopping areas [such as] Tsim Sha Tsui and Causeway Bay,”
5. “The second quarter was worse than the first quarter. But it is not a significant plunge. It is worsening gradually. The hotels [sector] is not optimistic, nor is retail.
6. “Will it be worse than [the 2008 financial crisis]? It is possible but … I do not have a crystal ball. I hope there will not be such a big wave.”
7. “Demand is weakening. In the short term, we think the outlook is not very optimistic,”
8. “Currency is a very important factor … As the Hong Kong dollar strengthens, it has a very big impact on Hong Kong’s overall consumption and demand,” “Yesterday, the yuan broke the 7 [yuan to a US dollar] threshold. This is an even bigger warning.”
9. “In these few months, all tenants suffered from a certain degree of impact,”
10. “We have to pray for the best, and hope the situation improves,”
11. “How long will it take? It is difficult to determine.” A drop in office rents in the second half, if any, will be in single digits,

When you put out information to the media and shareholders, you will wish to control the narrative. Some of my peers will say there is no value in attending AGMs or results brief.

I will say attending these briefs gives me some insights on the narrative of things the management cannot provide in data. You have to view these subjective data in the context of what they have been saying in all these briefs. If a certain management have always been positive, positive, positive and suddenly become…. withdrawn in their outlook, it may be significant enough to take note.

Management usually tries to give a balanced narrative. Some companies with less substance will talk up their company. So these tend to paint a rather positive picture.

But man, Doreen and Stephen were asked some tough questions and they are not hiding much. From what they say, in the short term, you will expect the second half results to be not as good. Just to what extend it is not good.

Recall that we annualized the earnings and say the earnings yield is 7.6%. Going forward, at least in the short term, the earnings yield might not be as high as 7.6%. As a longer term investor, what we are more concern of is not these short term earnings yield BUT the longer term ones.

This might be murky because… has Hong Kong permanently been altered? Would the international retail scene changed in a permanent manner? How fast is this change? How secular is this change?

The above questions are the more pertinent ones than all the pictures of the riots and mayhem.

Some short term changes remained short term. Those are noises. Some… become secular. Those are the ones that may make a gem like Wharf REIC become a value trap.

The history shows us evidence of quality or absence of quality. True quality is a moat. Short term it gets disturbed. The stock price may be mispriced. However, when the quality really disintegrates, then it becomes a real value trap.

If you run a concentrated portfolio, you make educated bets. If quality retains, your portfolio will flourish as a result. However if quality disintegrates, your portfolio will take a big hit.

This is what makes individual investing tough. There is value in good critical thinking. But that is not enough, you also need to go at least deeper into understanding something more than crowd. You also need more info about the business more than the crowd.

There will be those that say this is a secular shift bet on it. There will be those that say this is not a secular shift and bet on it.

I write more about my thoughts on active investing below.

Do Like Me on Facebook. I share some tidbits that is not on the blog post there often. You can also choose to subscribe to my content via email below.

I break down my resources according to these topics:

1. Building Your Wealth Foundation – If you know and apply these simple financial concepts, your long term wealth should be pretty well managed. Find out what they are
2. Active Investing – For the active stock investors. My deeper thoughts from my stock investing experience
3. Learning about REITs – My Free “Course” on REIT Investing for Beginners and Seasoned Investors
4. Dividend Stock Tracker – Track all the common 4-10% yielding dividend stocks in SG
5. Free Stock Portfolio Tracking Google Sheets that many love
6. Retirement Planning, Financial Independence and Spending down money – My deep dive into how much you need to achieve these, and the different ways you can be financially free
7. Providend – Where I work doing research. Fee-Only Advisory. No Commissions. Financial Independence Advisers and Retirement Specialists. No charge for the first meeting to understand how it works