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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.
