Executive Summary Having captured almost 13% of the total market capitalization of the Hong Kong stock market, and with its name on every one in twelve private residence in Hong Kong, you can get a glimpse of just how big Cheung Kong really is. In this small region, Cheung Kong has been the pillar for the economy. Its stock price started from around HK$1 in 1972 to HK$116 in 2000. Even today, given the current economic condition in Hong Kong, Cheung Kong is still priced at HK$44, the highest of the real estate industry. However, just how much does Cheung Kong worth? What is its investment risk? In addition, we should take Hong Kong’s property market into consideration given that Hong Kong is still struggling with deflation due to the depressed housing sector following four years of painful economic adjustment. Does the current stock price correctly capture the risk of the property market, or the stockholders are simply overconfident at this stock? The goal of our group is to present a detailed analysis of this company to Mr. Jacky Chan, to facilitate his decision regarding the attractiveness of the investment. First, we will present an overview of the economic condition of China and Hong Kong. Second, we will analyze the risks involved when investing in Cheung Kong, specifically economic risk, country risk, and company risk. Next, we will discuss the performance of the property market as well as its future outlook. Then, we will look at the company’s current performance. Lastly, we will wrap up this proposal with stock valuation and our recommendation for Mr. Jacky Chan. Introduction Mr. Jacky Chan is the action movie superstar in Hollywood and Hong Kong, who holds shares of Cheung Kong Holdings. His son is soon to be married. Mr. Chan, wanting to give his son and future daughter-in-law a gift for their wedding, is considering to sell his 100,000 shares of Cheung Kong stock. For a Chinese, everything has to mean good fortune during a time of celebration. Cheung Kong, almost of derivative of Cheung Gau, meaning eternity, has a great connotation as a wedding gift. However, as Mr. Chan sits in his sofa overlooking the Hong Kong skyline and the Victoria Harbor, he contemplates whether he should give his son the monetary gift after selling the stock or simply the stock. Being a Hong Kong lover and Hong Kong’s representative for Tourism, Mr. Chan sees Hong Kong’s future prospects very promising. Although the real estate industry in Hong Kong has fluctuated tremendously in the past years, he thinks that it ought to rise again, and the economy of Hong Kong is bound to survive the current crisis and have another wave of boom years. As a result, Cheung Kong stock might indeed grow in value and Mr. Chan does not want to sell the stock now if he knows it can earn bigger return in the future. As a result, he has employed several analysts to perform an extensive analysis on Cheung Kong Holdings Limited. Background Cheung Kong Group provides a full range of professional building management services. The company building management subsidiaries jointly manage over 95 million square feet of premises. And its combined market capitalization amounts to HK$405 billion as of March 15, 2003. The Cheung Kong Group operates in 41 countries and employs over 163,000 staff worldwide. A subdivision, Cheung Kong (Holdings) Limited is a publicly traded property development and strategic investment company. The company is one of the largest developers in Hong Kong for residential, commercial, and industrial properties. About one in twelve private residences and many notable landmarks in Hong Kong were developed by the company. The company also has substantial interests and operations in life sciences and the IT and internet business arena. The company’s long-standing policy is to continuously enhance quality and introduce innovations and initiatives to cater to changing needs and trends in the property market, with the aim of brining quality to our customers. The most important asset that Cheung Kong holds is probably its Chairman, Mr. Li Ka-Shing. Li, the richest man in Hong Kong, is actually a frugal billionaire, given that he started his career as a factory labor. Right now, Li’s biggest concern is his legacy. His businesses flourish on personal trust and an aura of respect that Li has cultivated for a lifetime. He draws no salary from public companies except for an annual Cheung Kong director's fee of $645. After all, his dividends in fat years come to more than $160 million. “In the current political environment, I’d rather do a bit less,” this was the response Li addressed to the public during the Asian financial crisis. Being called the Superman for his daring investments in downturn times, this news stirred up a storm in the Hong Kong investment community. Experts predict that the reason for this is due to Li’s concern for Hong Kong’s stalled economy. As he sees it, the city needs to go through a painful adjustment to recover its competitiveness as a regional business center. "Every place in Asia is cheaper than we are," he remarks. Li, who is building a skyscraper in central Tokyo, has discovered that Hong Kong's construction costs are higher than Japan's because of relatively low productivity. Though bruised by the Asian financial crisis, Li's companies have avoided critical wounds. As he tells it, "We were always prepared for the worst." Having diversified into infrastructure and utilities overseas, Li argues that his total portfolio of businesses "will yield stable income no matter how bad the economy gets" in Hong Kong. While Li understandably talks up his empire, most securities analysts are just as high on its growth prospects. Cheung Kong, Li's flagship property developer, owns half of Hutchison Whampoa, a conglomerate that runs all those port operations, mobile-phone services around the world, toll roads and bridges in mainland China, and much more. Goldman Sachs terms Hutchison "Li's juggernaut" for creating value and "the most liquid company in Hong Kong" (with an estimated $5 billion in cash). Li is also known for his conservative accounting: Hutchison has a debt-to-equity ratio of only 30%. Since the middle of 1997 the stocks of his companies have fallen about 20%. "Like other Asians, the value of my assets has dropped," says he, "but the most important thing is to have a quality company and a good business." Li, in fact, has invested $167 million of his own money in shares of Cheung Kong since October 1997 and now owns about 35% of it. His estimated personal net worth totals at least $6 billion. "I never calculate my wealth deliberately, but you can say that all my investments have been extremely conservative," Li explains. "I do not have any personal debt. That's why I sleep so well." Economic Overview Hong Kong, being the Special Administrative Region of China, has its own operating system. Over the past five years, external demand for China’s output has been affected by the shocks of the Asian financial crisis (1997-98) and the global economic slowdown (2001). In addition, the increasing pace of corporate reform as well as weak rural income put downward pressure on domestic consumption and investment. In the face of weakened external and domestic demand, the government engaged in expansionary fiscal monetary policies to sustain growth and job creation. Consequently, the economy managed to maintain an average growth rate of 7.8% over the period 1997 to 2001. Expansionary fiscal policy, especially an increase in government infrastructure spending, continued in 2002, which has contributed to maintaining growth in domestic demand. The growth rate of corporate income taxes fell from 47.2% in 2001 to 11.7% in the first half of 2002. Monetary policy has also been broadly used throughout the past five years. Interest rates were reduced successive steps in 1998 and 1999. By August 2001, it was clear that China’s economy had regained its growth momentum. This was due to the combination of an increase in external demand resulting from the moderate recovery in the global economy and expanding foreign direct investment, as well as the effect of the domestic stimulating measures. However, deflation, which had re-emerged in September 2001, continued throughout 2002. In china, property investment, which rose 33% in the first-half, accounted for about a quarter of total fixed asset investment. Property sales reached about 7.5% of GDP. There was also a significant linkage to the financial sector through loans to the construction sector, property developers and households. Housing mortgage loans reached RMB 650 billion by June 2002, accounting for about 10% of the total stock of outstanding loans of all financial institutions. Property prices have been rising rapidly, with prices in Shanghai increasing 30 to 50 percent over the past year. This was substantially boosted by speculative demand, which was estimated by the market to account for over 20% of the purchases. On the other hand, the economy of Hong Kong suffered a sharp slowdown in 2001, which GDP growth decelerating to a virtually stagnant 0.1% from 10.5% in 2000. The major contributing factors were declining exports and weakening of consumer and business sentiment, stemming from the difficult economic environment worldwide. Expansion in private consumption fell to 2% from 5.4% over this period, reflecting consumer sentiment that was undermined by a drop in asset prices and rising uncertainty over employment. Expenditure in building and construction declined further by 2.5%. Private sector developers remained cautious in view of the overhang of supply in residential property market while residential public sector projects were also scaled back. Home mortgage loans in “negative equity” in Hong Kong rose on a quarterly basis at the end of December, reflecting a decline in local property prices. The number of negative equity loans – where the outstanding mortgage exceeds the value of the property – rose to 76,686 at the end of the year from 70,112 at the end of September; the Hong Kong Monetary estimated the total value of loans as HK$127 billion (US$ 16.3 billion). Hong Kong’s real estate sector, a key barometer of the health of the local economy, has shown few signs of recovery since the Asian financial crisis. Residential property prices are 65% below their 1997 peaks. They have been hurt by oversupply and anemic demand. Banks have been lowering interest rates to help reduce repayment burdens on negative equity homeowners. Investment Risks and Concern Economic Risks and Concern Hong Kong Hong Kong's economy has slowly recovered from the setback brought about by the global slowdown since last year. Its GDP grew modestly by 2.3% in real terms in 2002 as against merely 0.6% a year earlier. Because of the cut of the short term interest rate in the US that Hong Kong government decided to follow, the short term interest rate in Hong Kong has recently decreased to a historically low number, which reflects an expectation of further economic recession in Hong Kong. Although it seems that the low interest rate would facilitate the housing projects in Hong Kong, due to the positive response of the rate cut shown by the instant rise in the equity markets; however, there is a risk that the interest rate is going to increase sooner or later because there are no more tendencies for the interest rate to decrease. During the past few years, Hong Kong has announced many times of cuts in interest rate to help stimulate the local economy, both in terms of consumption and the residential property market, but there is no significant impact on the market as a result of the cut. Therefore, as the interest rate has already reached the lowest level, at about 2% per year; with a slowly recovered GDP of the market, the Hong Kong government might not plan to increase the interest rate in the near future, in which the investors, including Cheung Kong Holdings, will be better off. People’s Republic of China (PRC) Despite the slower growth in world economy, China’s real gross domestic product (GDP) has experienced significant growth in the past decade, mainly due to the strong domestic consumption and investment. Real GDP growth in China is expected to be increased to an average of 7.9% a year in 2002 and 2003. Consumer prices are projected to fall by 0.6% in 2002 and to rise by only 0.4% in 2003. The current-account surplus will decline from an estimated US$19.9bn (1.7% of current-price GDP) in 2001 to US$8.8bn (0.6% of GDP) in 2003. The domestic demand of PRC, which is a key to sustained long-term growth, is being stimulated through an expansionary public investment program. However, with different programs carrying on at the same time, such as strengthening the financial system, developing legal and regulatory framework for the economy and promoting the role of private sector, which are the key challenges that China has to face in the coming years, the targeted long-term growth whether or not could be induce by increasing domestic demand remain largely uncertain. Furthermore, China's leadership wants continuing economic liberalizations and sustainable growth, but also enduring and pervasive political control. Reform of loss- making state-owned industry and the indebted state-owned financial sector is essential, but the provision of a wide range of welfare benefits to current and former employees makes this difficult. The government is using international obligations arising from China's accession to the World Trade Organization (WTO) to push through reforms against the resistance of vested interests. Implementation of reforms, however, will be imperfect. The increase in foreign competition facilitated by WTO accession will expose the weakness of the state-owned sectors of the economy. Country Risks and Concerns Hong Kong The economy of Hong Kong, China suffered a slowdown in 2001, with GDP growth decelerating to a virtually stagnant 0.1% from 10.5% in 2000. The major contributing factors were a drop in exports and a weakening of consumer and business sentiment, stemming from the difficult economic environment worldwide. Domestic demand growth slumped to 0.2% in 2001 from 10% in 2000. Expansion in private consumption fell to 2% from 5.4% over this period, reflecting consumer sentiment that was undermined by a drop in asset prices and rising uncertainty over employment. Given the bleak business outlook, gross fixed capital formation averaged a 2.1% increase, compared with a 9.8% rise in 2000. Slower growth in capital expenditure was mainly due to a sharp slowdown in the growth of spending on new machinery and equipment in 2001 as corporations cut their investment in information and communications technology upgrades. Expenditure on building and construction declined further by 2.5%, the fourth year of contraction. Private sector developers remained cautious in view of the overhang of supply in the residential property market while residential public sector projects were also scaled back. With the weakening demand in the economy, inventories underwent a modest depletion in 2001 after a substantial buildup in 2000. Labor market conditions deteriorated during the year. The seasonally adjusted unemployment rate, having trended downward from a peak of 6.4% at the beginning of 1999 to 4.4% in the fourth quarter of 2000, edged up to 6.1% by the fourth quarter of 2001. The rise was attributed to increased corporate downsizing and layoffs in the context of slowing aggregate demand and the skills mismatch caused by ongoing economic restructuring. Partly as a result of a sustained fall in import prices, a depreciation of regional currencies against the US dollar, and a benign external inflationary environment, deflation took hold, as the consumer price index fell by 1.6% in 2001. Fierce retail price competition and a weak property market that resulted in falling property rentals also put downward pressure on prices. People’s Republic of China Because the Chinese government’s imminent accession to the WTO, the government is currently reexamining its existing laws and statutes in accordance with the framework of the WTO. It has abolished certain obsolete laws and regulations, and will gradually revise the laws and regulations that are incompatible with the rules of the WTO. For instance, in 2000, China revised The Law of the People's Republic of China on Chinese-Foreign Contractual Joint Ventures and The Law of the People's Republic of China on Wholly Foreign-Owned Enterprises, and discarded certain restrictions regarding the balance of foreign exchange account and localization of supplies. In 2001, The Law of the People's Republic of China on Chinese-Foreign Equity Joint Ventures was also revised. However, because these laws are relatively new and untested, the enforcement of these laws under the improving law system of China involve significant uncertainty. Since China is an emerging market and a developing country, investors are facing more risk when they invest in China as oppose to developed countries like the US, specifically currency exchange risk and political risk. Low confidence will adversely affect the investor’s decision to invest in Cheung Kong. Currency Exchange Rate Risks and Concerns The Asia financial crisis happened in 1997 has a dramatic impact on Hong Kong financial market and Hong Kong has suffered from economic downturns since then. With most of its operation located in Hong Kong, any changes of the Hong Kong currency would affect Cheung Kong Holding’s significantly. Although there is a deflation observed in the market in the past few years, however, the Hong Kong dollar had remained constant because the Hong Kong currency is linked to the US dollar under a currency board system managed by the Hong Kong Monetary Authority under the framework of the Linked Exchange Rate System established in 1983. Due to the linking system, Hong Kong currency has been able to remain constant even when it was suffering from economic turndowns throughout the years. However, since Cheung Kong Holding’s also has a big share of its business invested in China and even London, any restrictions on currency exchange might still limit Cheung Kong’s ability to utilize its revenue to fund its business activities with China and outside Hong Kong. Company Risks and Concern Cheung Kong Holdings has reported increasing net profit during the past decades. However, the increase has been slowed down during the recent years because of the economic turndowns in the world. Also, the real estate market in Hong Kong has become saturated because it has been dominated by few large companies such as Sun Hung Kai Properties Limited and Hang Lung Properties Limited, and this is also a main reason that has slowed down the increasing revenue of Cheung Kong Holdings’ investments. Because of the saturated market in Hong Kong and difficulties to obtain larger market shares, the company is actively investing outside Hong Kong, mainly in China, and all over the world. However, the losses obtained by its subsidiaries companies, such as Hutchsion Whampoa and Tom.com, have decreased Cheung Kong Holding’s net profit or even have a potential threat to create a loss of the parent company. Therefore, since Cheung Kong Holdings is a large corporation with many subsidiaries, the success of Cheung Kong Holdings depended on its ability to operate both the parent company and the subsidiaries efficiently and less costly, with a stabilized currency system and favorable government real estate policies. Real Estate Industry in Asia Real Estate Industry in China China’s rapid economic growths, rising per capita income and flood of foreign investment into the country are all creating opportunities for the real estate sector. However, investments in the sector in the first half of 2002 grew at a much faster pace than sales. Strong demand has done little to dampen developers’ interest in the market, mainly because the real estate sector remains highly profitable in China with annual profit margins averaging 20 percent, double the average profit ratio of other industries. Hong Kong’s sluggish real estate market is tempting some of the territory’s property developers to look for markets across the border. Hong Kong’s major developers, including Cheung Kong Holdings and Sun Hung Kai Properties have developments in the Mainland. However, they are taking a cautious approach to the market. Sun Hung Kai Properties' latest annual report showed that less than 10 percent of its turnover came from outside Hong Kong. Cheung Kong Holdings has a number of projects in China, including Guangzhou, Shenzhen, Dongguan and Zhuhai in South China. It also has operations in eight Mainland cities, but again these operations contribute a small percentage, just 7 percent, of the group's total turnover. Part of the reason for Hong Kong developers' cautious approach to the Mainland market is obviously because China's real estate market has yet to be fully regulated, which means relationships between developers and local governments remain very important. Also, land auction prices are generally 20 per cent higher than the government's agreed selling prices. Increasing attention has also surfaced of late regarding the possibility that China’s property boom may actually be nearing bubble proportions. Fueled by growth in the real estate industry, fixed-asset investments in China rose 24% during the first 10 months of 2002 over the same period in 2001, but investment in real estate jumped 36.6%. China’s existing residential property vacancy rate stands at around 26 percent, while it is around 7 percent for the United States and 3 – 4 percent for Hong Kong. The international alarm vacancy level is 10 percent. The high vacancy rate, however, is a result of the expensive, low-quality housing left over from the planned economy. This is clearly reflected in the low vacancy rate among private developers’ properties. It also explains why housing prices have remained stable in the face of a technically high vacancy rate. Mainland investments in the real estate sector hinge on the government's macro- economic strategies, because the real estate sector contributes about 1.6 percent to China's GDP growth. Hong Kong Housing Market Overview To understand Hong Kong’s property market, we must first time take a journey back to the past. Hong Kong went through a strong inflationary tread that lasted for decades before the Asian financial crisis hit the regent in 1997, which brought along a rare bout of deflation that still lasts today. Economic contraction in Hong Kong has never previously resulted in inflation dipping below zero and recovery was invariably quick. The present deflationary situation is unique. On the one hand, the economic adjustment needed after the crisis was substantial; on the other, this adjustment could only be achieved through real cost reduction. To restore external competitiveness, Hong Kong's property prices and wage costs had to fall and this inevitably led to serious deflation. In the more than five years since the outbreak of the crisis, Hong Kong property prices have roughly halved from their peak and wages have been slashed or frozen. Housing has had the greatest influence on the CPI (Chart 1), much stronger than its proportionate share of the index, and continues to be a drag on the overall price level. This suggests that a reversal of Hong Kong's deflationary condition will mainly depend on housing costs. If housing costs rise, Hong Kong's deflation will improve, and vice versa. Thus, the question is whether property prices will rise in the foreseeable future. The widely held view is that the excess supply of housing units will depress any rise in residential property prices. Indeed, the property market of Hong Kong is still flooded, with some 20,000 completed and 30,000 uncompleted private residential flats available for sale. Excess supply will not be absorbed so quickly. Buyers are not likely to enter the market until there is some indication that the downward trend has bottomed out. Of more importance is the change in attitude towards property following the Asian financial crisis, whereby property is no longer treated as a major investment vehicle. This effectively reduces both speculative demand and the gearing for property investments. However, there is an increasing possibility that the property market outlook will improve in the near future. Housing prices have fallen substantially over the past two years, while household incomes have retreated to a much lesser extent. Despite some adverse interest rate movements over the period, the share of household incomes taken up by mortgage payments dropped markedly, which indicates that homes are more affordable today than they were in 1997. Using median household income as a measure, residential property prices are now 65 percent below their 1997 peaks (see Chart 2). This level is much better than the troughs of the previous two economic cycles, in 1994 and 1990, and suggests that current property prices are very attractive. If affordability were the only consideration for home buyers, with other factors at a constant, property prices could be assumed to have reached the bottom of the cycle. Despite the optimistic outlook, at present the economy is not generating sufficient saving relative to its debt outstanding. Home mortgage loans in "negative equity" in Hong Kong rose on a quarterly basis at the end of December, 2001. The number of negative equity loans -- where the outstanding mortgage exceeds the value of the property -- rose to 76,686 at the end of the year from 70,112 at the end of September. The overall financial portfolio of Hong Kong residents has to improve before they will take on more debt. Under the current situation of wage freezes and high real interest rates, until a 'safe' level of debt has been reached in relation to savings, a larger mortgage would cause undue economic hardship. A sharp improvement in economic conditions is needed to improve prospects for wage and income growth, making it more acceptable to increase borrowings. In order to help the property market pick up its momentum, earlier in November 2002, the government introduced a new set of housing policies and some specific measures to facilitate the efficient operation of the property market and restore public confidence. The role of government in the property market is to be reoriented mainly to issues on land supply and provision of rental assistance to low-income families. Noting that supply and demand imbalance exists in the property market, the government has decided to stop all scheduled land auctions and call of the two remaining land auctions in the financial year ended March 2003. The government has also decided to suspend land application from developers until end of 2003. Thereafter, the supply of new land will be triggered only from land application, not land auctions. Analysts at the Hong Kong General Chamber of Commerce’s seminar on housing say that the government’s new policy to control the supply of land, in addition to the pent-up demand from past several years and record low interest rates could push demand for new flats up by as much as 40 percent in 2003. Last but not least, comparing incomes, taxes, and home prices with similar cities such as New York, Sydney, and London, Hong Kong comes out well ahead. After taxes have trimmed disposable income, residents of these other cities need to earn up to 60 percent more than a Hong Kong resident to buy a comparable flat. The reason Hong Kong residents are so much better off than their international counterparts is because they are taxed at a rate of 15 percent as compared to 30 - 40 percent for other world cities. Cheung Kong Holdings As a fully-integrated, multi-discipline property development company, Cheung Kong Holdings is one of the largest property developers of residential, office, retail, industrial, hotel and property in Hong Kong. With its long history of property development expertise, Cheung Kong Holdings has built many of Hong Kong's most notable landmark buildings and complexes. The company is also a leader in marketing and after-sales services. Foreign Market Developments Cheung Kong Holdings aims to maintain a strong presence in overseas property markets as a quality property developer in choice residential and commercial projects. Since 1992, Cheung Kong has entered into a number of joint venture agreements (in many cases, with Hutchison Whampoa) to develop properties in the Mainland. There are now projects in Beijing, Shanghai, Qingdao, Chongqing, Fuzhou, Guangzhou, Dongguan and Zhuhai. Cheung Kong will also continue to look for potential development opportunities in other Mainland cities. Other overseas markets where Cheung Kong Holdings has a presence include Singapore and the United Kingdom. Mainland China Properties Beijing Oriental Plaza The Beijing Oriental Plaza features a total construction area of approximately 800,000 square meters and is the largest commercial complex in Asia. The Plaza consists of two sections: The Malls, comprising five theme shopping and entertainment centers, water fountain, garden and one of the world's largest car-parks; and The Towers comprising eight grade-A office towers, four blocks of serviced apartment, and a five-star hotel. Beijing Lido Place Lido Place is conveniently located next to the Fourth Ring Road, a major transportation highway of Beijing. Whether going from Lido to the city center or to the airport, traveling time is only about 15 minutes. Lido Place consists of the 726-room Holiday Inn Lido, 12 restaurants and pubs, 364 apartments, a 210,000 square foot grade- A office tower, an entertainment and shopping complex, a country club, an international school and an extensive garden. Shanghai Seasons Villa The Season Villas development covers 1.3 million square feet of houses, apartments and a clubhouse in the Pudong Huamu district. The final phases of the project are scheduled for completion in 2002. At a nearby site with planned gross floor area of 1.7 million square feet, a new development comprising villas and apartments will be built over the next six years. Shanghai Westgate Mall Tower A 1.05 million square foot commercial development at Nanjing Road West, the Westgate Mall Tower comprises a shopping center, office premises and a large number of parking spaces. The shopping center has been open since mid-1997 with anchor tenants such as Isetan Department Store, PARKnSHOP, Watson's, Mei Long Zhen King's Village Restaurant, UA Cinema, Food Junction, Burberrys, Ermenegildo Zegna and Versace. The office tower was completed in November 1997 and tenants include many well-known multi-national corporations. Qingdao Pacific Plaza The Pacific Plaza is an office and low-rise residential development of 847,000 sq ft. Phase one of the development, which was completed in 1996 has a gross floor area of 356,000 sq ft. It comprises seven blocks of garden duplexes; a clubhouse; a 19-storey office building, which was purchased by Tsingtao Beer for use as its headquarters; and two three-story office buildings with a high-class shopping center and car parking spaces. Phases two and three of the residential development feature four high rise apartment towers with gross floor area of about half a million sq ft. The first two towers were completed in 1998, while the remaining two high-rise residential towers are expected to be completed in 2002. Chongqing Metropolitan Plaza Metropolitan Plaza, a two million square foot commercial and hotel development in central Chongqing, is one of the largest comprehensive projects in southwest China. Awarded the Chongqing Architectural Bai Hua Prize in 1998, Metropolitan Plaza has been well known for its outstanding design. Since August 1997, the shopping mall has acquired numerous brand name tenants such as Pacific Department Store, Watson's, Givenchy, Ports, Alfred Dunhill and Acquascutum. A 22-lane bowling center, an ice- skating rink and a cinema are also on offer to entertain shoppers. As the first five-star hotel in Chongqing, the Harbour Plaza Chongqing offers a total of 425 rooms and suites to international travelers. The 24-story office tower in Metropolitan Plaza has become the offices of the Hong Kong and Shanghai Banking Corporation, Ericsson, IBM, Philips and many others. United Kingdom Properties Albion Riverside Cheung Kong Holdings has a 45% joint venture interest in a site at the Albion and Bridge Wharves, which is being developed into a residential and commercial development totaling 391,000 sq ft for completion in 2003. Chelsea Harbor Phase II Cheung Kong Holdings has a 22.5% interest in a 169,000 square foot residential development in phase two of the Chelsea Harbor development on the River Thames, which is due for completion in 2003 and 2004. Company Performance Our analysis of Cheung Kong’s financial performance starts with a series of ratio analysis, including short-term liquidity risk, long-term solvency risk, and profitability ratio analysis. In order to determine Cheung Kong’s financial soundness, we will benchmark its performance against Sun Hung Kai in our ratio analysis. Liquidity The current ratio is a measure of short-term liquidity risk and in most cases, we would expect to see a current ratio of at least 1. Cheung Kong’s current ratios for years 1999 to 2001 were above 1, which show that it has a high level of liquidity. The quick ratio decreased over the three year period while the current ratio increased. As we can see from the numbers in the appendix, Cheung Kong seemed to have used up some of its cash and securities to pay off liabilities and purchase inventory. This would explain why the two ratios have changed in opposite directions. The use of cash to purchase inventory in 2001 is also reflected in the decline of the cash ratio for Cheung Kong. The ratios we calculated for Sun Hung Kai were very similar to that of Cheung Kong, which indicated that Cheung Kong was performing on industry level and presented no short-term liquidity risk. Leverage Long-Term debt ratio is used to measure the amount of liabilities, particularly long-term debt, in a firm’s capital structure. The higher this proportion, the greater the long-term solvency risk will be. A long-term debt ratio higher than 1.0 is highly unusual since it requires a negative shareholders’ equity. Our calculations indicated that both Cheung Kong and Sun Hung Kai’s long-term debt ratio increased consistently through the three year period from 1999 to 2001. Although the ratios of both companies were substantially below 1.0, Cheung Kong’s long-term debt ratio was lower than that of Sun Hung Kai, which is an indication that Cheung Kong relies more on equity than debt financing as compare to Sun Hung Kai. Cheung Kong’s debt-asset ratio was lower than Sun Hung Kai’s in the past three years, inferring Cheung Kong’s advantage in borrowing additional funds from creditors because of its relatively low debt utilization. The interest coverage ratio indicates the number of times that net income before interest expense and income taxes exceeds interest expense. A coverage ratio of less than approximately 2.0 is commonly viewed as risky situations. Cheung Kong’s interest coverage ratio was decreasing from 88.18 to 6.87. The dramatic change was due to a surge in net income in 1999 followed by a consecutive drop in 2000 and 2001. Operating cash flow to total liability ratio is an indication of a company’s ability to generate enough operating income to cover its liability. A ratio of 0.2 or more is common for a financially healthy company. Cheung Kong had operating cash outflow for consecutively three years. A large part of this negative cash flow was due to “share of results of associates”, an account arising from the merger of VoiceStream Wireless Corporation and Deutsche Telekon AG recognized by Hutchison Whampoa Limited. If we took away “share of results of associates,” the operating cash flow to total liability ratio for Cheung Kong would be above 0.20 for these three years. Profitability Cheung Kong’s profit margin is exceptionally high, with well over 100% in 2000 and 1999 due to the fact that most of the profit is generated from share of net profit of Hutchison Whampoa Limited. Hutchison Whampoa Limited is an associate company in which Cheung Kong has long term equity interest of more than 20%, and exercises significant influence over its management. Even though Cheung Kung has much higher profit margin, it is decreasing dramatically over the past three years, which was mainly due to the decline of profit in Cheung Kong’s associate company, while Sun Hung Kai’s profit margin has increased from 40% to 47%. Cheung Kong’s operating profit only accounts for 16%, 12% and 2% of profit before taxation for years 2001, 2000 and 1999 respectively, whereas Sun Hong Kai’s operating profit accounts for more than 70% for the past three years. As a result, Cheung Kong’s profitability is more volatile as compared to its competitor. Cheung Kong’s return on asset has been decreasing over the past three years mainly because of the increased investment in associates as well as in the jointly controlled entities, therefore, increasing total assets. In addition, dramatic profit decline in share of results of associates had led to decreases in Cheung Kong’s net profit. Return on equity measures the rate of return on a common stockholder’s investment. Cheung Kong is experiencing decreases in ROE for the past three years. However, Cheung Kong suffered from a sudden drop from 46% down to 6% in year 2000 due to profit decline in its associate. As evidenced by the substantial decrease in all Cheung Kong’s profitability ratios, 2000 was a disastrous year for Cheung Kong. We deemed this to be an anomaly, leading the 1999 and 2001 ROA, and ROE ratios, all which to be below Sun Hung Kai’s. 2000’s performance suggests that Cheung Kong should attempt to better control its influence in associates and jointly controlled entities, and reexamine its strategies in order to increase overall profitability. Analysis of Valuation As of March 28, 2004, the stock of Cheung Kong Holdings was HK$44.60 while the Dividend Discount Model showed that the value of stock should be HK$26.68. Why was there a 40% difference? The overvaluation of price can be justified for the following reasons: Brand Image After the Asian crisis of 1997 and 1998, the issue of corporate governance has become more significant when people are less willing to overlook management shortcomings. Investors have strong confidence in Cheung Kong due to the company’s 53 years of outstanding performance, and its exceptional founder, Mr. Li Ka Shing. Cheung Kong (Holdings) Limited was listed on the Hong Kong Stock Exchange in 1972, after only 31 years, the Cheung Kong Group of companies is capable of generating a combined market capitalization of approximately HK$405 billion, and survived through numerous financial crisis. Cheung Kong has the financial resources and management conviction to take chances when other must scale back. To be more specific, Li has the ability to push forward at the moment of maximum pessimism when no one else can. Li is the single largest shareholder of Cheung Kong, who holds 36.53% of the company. He is ranked as the 23rd wealthiest man in the world with a 10 billion dollar fortune in 2002, however, slipping from 18th place and 12.6 billion a year before. The historical performance and solid balance sheet of Cheung Kong and the record of success of Li have made “Cheung Kong” a well known brand across Asia, and maintained investors’ confidence in the company despite the swirling pessimism. Stable Dividend Growth During market recession, investors tend to look to conventional defensive plays such as utilities, consumer staples, health care, and high-dividend yielding stocks. However, Hong Kong market lacks such defensive stocks. In addition, Hong Kong interest rates have been falling as the U.S. Federal Reserve keeps easing, which drove the average rate for bank deposits in Hong Kong to be less than 1%. Consequently, investors look to invest in companies that have stable dividend distribution as an alternative. As a result, Cheung Kong is viewed as a favorable investment since it has an average growth rate of 3.0% over the last 6 years. Investors are willing to pay a premium price for the stock in order to receive constant return on their investments. Cause for the Instability of Earnings per Share Steady earnings growth was another important determinant when evaluating a company. For the past 6 years, even though Cheung Kong has steady dividend growth, it still reported fluctuated payout ratio due to instability in earnings. In 1999, Hutchison Whampoa sold off the British telecom operator, Orange PLC, in a two-step transaction and parlayed the investment into a $22 billion profit for shareholders. Since Cheung Kong has a 49.9% holding in Hutchison, the sale contributed to the rapid growth of EPS from 1998’s 2.66% to 25.84% in 1999. Then, before the dust settled, Hutchison Whampoa bought a next-generation mobile phone license in Britain for a modest fee. Although real estate development is Cheung Kong’s core business, its earnings are also dependable on performances of its associates and jointly controlled entities. As a result, investors should always take this into consideration and not to overlook Cheung Kong’s earnings per share ratio. Hong Kong Property Market The Hong Kong property market has been diminishing since prices peaked shortly after the city’s handover to China in 1997 given that Hong Kong’s fortunes remain tied to the vagaries of the real estate market. In addition to diminishing prices, government was proceeding with long-standing plans to provide subsidized apartments through both sales and rentals in order to raise the percentage of homeownership. However, this would only depress the price further since private flats have become more affordable. In 2000, a family earning up to $3,600 a month qualifies for a subsidized apartment, yet a Hong Konger needs income of just $2,500 a month to afford a mortgage on an entry-level private flat. Since the Asian financial crisis, property is longer treated as a major investment vehicle, therefore, effectively reduces both speculative demand and the gearing for property investments. There is no reason to invest in property with little hope of realizing any capital gain and a disappointing rental yield. However, in November 2002, the Hong Kong government announced nine measures to stabilize property prices. These measures included the issues of the supply of construction land and railway land, the government housing programs, the loan schemes, anti-speculation measures, etc. The government believed that the drastic measures to decrease land supply would have positive effects on property prices. Although the property market of Hong Kong is fully saturated, Cheung Kong has its own strategy on the flooded market. The company has focused on unloading flats quickly by utilizing a mark-to-market pricing strategy. In addition, Cheung Kong does not concentrate solely on domestic market but is also interested in China and international projects. The company becomes a major force in capturing the opportunities offered by the rapid developments in China. All in all, the future prospect for Cheung Kong’s growth is optimistic. Conclusion Even though Hong Kong is currently undergoing a recession, the real estate market still has sounding future based on new governmental policies as well as Cheung Kong’s market development strategies. Our investment risk analysis also indicated that Hong Kong and Cheung Kong are relatively safe to invest in. In addition, Cheung Kong’s own solid balance sheet and Li Ka Shing’s record of dealmaker, the company can sustain its performance and economic growth, and has the ability to survive through disastrous times. As a result, based on all of the above analysis, we recommended that Mr. Chan should hold the Cheung Kong stock and simply present them as wedding gift to his son since the stock does indeed have the potential to grow. Furthermore, not only is the connotation of the stock name appropriate, the growth of the stock will symbolize the flourishing of a marriage, thus, making it the best wedding gift. Teaching Notes Valuation We used the Dividend Discounted Model to measure the justified value of Cheung Kong’s stock price. The Dividend Discounted Model works best for firms with stable growth rates and dividend payout ratios. Our rational for using the Dividend Discounted Model on Cheung Kong is based on the following: 1. The firm is in stable growth. According to the historical data presented in the following table, Cheung Kong’s dividend growth is very stable, at approximately 3% over the last six years. Although the dividend payout ratio fluctuated quite drastically, a closer look at the Earning Per Share (EPS) number shows that the fluctuation in payout ratio comes from the irregular surge and drop in earning in year 1998, 1999, and 2001. If our sample include a longer period of time, the payout ratio would be approximately between 18% and 22% all the time. 1996 1997 1998 1999 2000 2001 DPS $1.38 $1.62 $1.16 $1.38 $1.60 $1.60 EPS $6.02 $7.66 $2.66 $25.84 $8.42 $3.15 Payout Ratio 22.92% 21.15% 43.61% 5.34% 19.00% 50.79% Growth of DPS 3.00% 2. Since dividend has to be financed by earnings, dividend reflects the long term earning power and profitability of a firm. 3. Earnings per share (EPS) is highly volatile compare to dividend. Therefore, it’s easier to forecast future dividend rather than future EPS. 4. Discounted Dividend Model is suitable when investor’s perspective is one of non- control (no premium for control is incorporated). The underlying intuition is that investor has no control of dividend-paying policy. Conversely, in the case of merger and acquisition, if firm A wants to buy firm B, firm A will value firm B by using FCFE rather than DDM because FCFE incorporates the premium for control. CAPM (Appendix A) We determined the elements of CAPM based on the following research and assumptions: 1. Risk-free Rate: Usually the interest rate of long-term government bonds is used as a surrogate for risk free rate, as the government should be credible to pay its debtors. Therefore the treasury bill rate of U.S. is viewed as the risk free rate on investments. Investors use this rate to compare with other investments. The Hong Kong Government does not issue government bonds. However, its Exchange Fund Bills obtained from Monthly statistical bulletin prepared by Hong Kong Monetary Authority can be viewed as such (Appendix A). 2. Market Return: We calculated the Geometric Return of Heng Seng Index for the last 15 years and used that as a representative of Hong Kong market return. (Appendix A) 3. Beta: There are three determinants that account for the differences of betas from different sources. They are the length of estimation period, return intervals, and choice of market index. Beta from the Bloomberg Terminal is based on the assumptions of 5 years of monthly returns against the S&P 500 Index. DDM (Appendix A) We determined the elements of DDM based on the following research and assumptions: 1. Formula for Justified Value of Stock Current EPS * (1+Growth of Earnings) * Payout Ratio / (Cost of Equity - Growth of Earnings) 2. Current EPS: We obtained current EPS from Yahoo Financial 3. Growth of Earnings: the growth rate of DPS 4. Payout Ratio: We used the payout ratio obtained from the most recent annual report and we assume that this payout ratio will be sustained to future years for both companies. Sensitivity Analysis (Appendix A) Sensitivity analysis stresses testing the assumptions we made for the DDM valuation. By doing sensitivity analysis, we will have more understanding on the sources of value and what the key drivers of value are, such as equity beta and growth rates. Based on the current price of $44.70 per share, we believe that Cheung Kong is currently over-valued by $17.92 ($44.60 - $26.68) per share. Furthermore, as we look into the sensitivity analysis closely, the value of stock is very sensitive to the change in the growth rate. For example, if the growth rate drops to 2% from 3% due to intense competitions and market maturity, value of stock will be $22.73 (holding other variables constant). So, we would conclude that the growth of dividends is one of the key drivers of the value of stock. From another perspective, assuming we are using the right model, the implied growth rate from the market price is 5.5%. Due to its huge market share in the commercial real estate industry and poor outlook for real estate market, it's unlikely Cheung Kong Holdings can increase and sustain its growth rate at the level of 5.5%. Another interesting finding from the sensitivity analysis is that as growth rate approaches cost of equity, the value of stock increases exponentially. It tells us that as the economy outlook improves, higher growth rate assumptions can be achieved and value is justified at a higher level. As shown above, equity beta is also a key driver of the value of stock since it determines the cost of equity; however, the sensitivity analysis tells us that stock price is less sensitive to beta compare to growth rate. As everything else stays constant, there is a linear relationship between equity beta and value of stock Overall, sensitivity analysis for Sun Hung Kai Properties has the same findings as Cheung Kong Holdings'. From our base-case assumptions, Sun Hung Kai Properties is over priced for $4.28 per share. However, we would conclude that it's fairly priced according to the sensitivity analysis. As we stress testing the assumption such as its growth rate and equity beta, it becomes under-valued if growth rate becomes 5% (only 0.77% higher than current growth rate). Therefore, based on the above valuation model and sensitivity analysis, we would conclude with a SELL recommendation for Cheung Kong Holdings and a HOLD for Sun Hung Kai Properties. Even though Cheung Kong is currently showing higher stock price than that of Sun Hung Kai, however, our analysis shows that Sun Hung Kai is actually outperforming Cheung Kong. However, taking other aspects into consideration as we have discussed in the case, Cheung Kong has substantial growth potential; therefore, it is more beneficial for investors to HOLD instead of sell.