Friday 10 January 2014

How to own prime property in Causeway Bay for only HK$14


Ever been to Causeway Bay in HK? If you had, you would most likely walked past Sogo which is right smack in the middle of CWB. And if you had just googled online, you would discover that Sogo is owned by Lifestyle International Holdings (1212 HK). 1212 HK currently trades at ~HK$14 and ~12x FY12  core earnings.

Company profile
1212 HK operates the Sogo department stores in HK - 1 in CWB and another in Tsim Sha Tsui (TST). It also operates the 久光百货 department stores in China, which is essentially the equivalent of Sogo. 久光百货 can be found in Shanghai, Suzhou, Dalian & Shenyang. The company owns all the stores with the exception of its Tsim Sha Tsui and Shanghai outlet. The Sogo and 久光 brands are targeted at the mid-high end market.

It also owns a stake in Beiren group, an operator of supermarkets, department stores & other retailing outlets in Shijiazhuang, Hebei. They hold a 49% stake of Beiren group, via a 60% owned subsidiary, thus giving them ~30% effective shareholding.

It also owns a stake in Lifestyle Properties (2183 HK), which will be the vehicle to pursue property development & investment projects in China. This is a subsidiary which is spun out of 1212 HK back in 2H 2013.

Overall, I think 1212 HK is a decent business operated by above-average management. I don't see it as a great business but maybe a good-enough business. It will be interesting for an investor who is able to find the right price that provides a good margin of safety to compensate for the risks (see main analysis below). 

The risks tend to revolve around macro concerns about China but on a company level, 1212 HK is well managed, pays a 4% dividend for the patient investor and has a strong balance sheet which allows for growth through acquisitions. In the short term, we might see some operational hiccups (see main analysis) but the silver lining is that it may create an opportunity to build a stake in the company at an attractive price.

Financials
The company has always been profitable (at least for the past 7 years that I looked at) and has grown core earnings by ~90% over the past 7 years, which is ~ 10% p.a. Profit growth has been positive in all years except 2008 during the financial crisis. Its associate, Beiren group, has also demonstrated tremendous growth across the years (net profit growth in 2012 was 26% y-y)

The balance sheet of the company is strong and is close to net cash levels, if you include its investment portfolio. Even without counting its investments, its net debt-to-asset-ratio is <15%. The business constantly generates free cash flow, some of which gets paid back to shareholders in the form of dividends. It has a 40% dividend payout ratio and its FY12 dividend was 49.4 HKcent, which is ~4%. 

Management
Overall, the company appears to be well managed as its HK operations has consistently outperformed its peers or at least performed on par. Its China operations has also performed well on average as year-on-year sales growth were positive, with the exception of the Dalian outlet which saw a down year in 2012. 

Management appears credible, as evidenced by the transparency of information in its reports. Having said that, I think it can share more on a timely basis. It seems that they have yet to do anything which is unfriendly to minority interests, which is a positive.

Quick evaluation
1212 HK is a good example of an average business run by an above-average management. 

Retailing is a difficult business and department stores are structurally challenged by the trend of online shopping. 

Its sensible strategy of owning its own outlets has given them a cost advantage over competitors which faced the brunt of rising rental cost. 

Across time, it has also built up a brand name in the markets it operates in and management has demonstrated competence by outperforming peers in generating sales through improving foot traffic, buy-stay ratio and ticket size per customer. 

Its strong balance sheet has allowed it to acquire growth across time and may still do going forward. It doesn't hurt that a rising tide of wealth creation in China has raised all boats, including theirs. 

Issues/Risks
Notwithstanding my opinion about management's competence (and they are not all perfect IMO), the business model is still structurally challenged in the long term. It is unclear how the business will perform when the tide of wealth creation in China recedes (or slows), which seems increasingly likely with each piece of data coming out from China. The worst case could see China turning into Japan with its decades of lost growth

In the short term, the company is also facing a hiccup with its Sogo outlet in TST, where it was unable to renew the lease and has to relocate by Feb 2014. I would imagine that this may mean higher rental rates and a short term depression in earnings contribution fom Sogo TST where it has to rebuild its foot traffic, especially if the new location is not as good as the old one.

There are also concerns that cost increases, primarily due to wage increases, could outstrip revenue growth and lead to a contraction in profit.

Valuations
It trades at ~12x P/E FY12 core earnings. The question remains as to what the right valuation should be if the structural growth of the industry & retail market slows as China economic growth moderates. 

Without doing a detailed peer comparison table, I note that its peers trade at a wide valuation range with Debenhams in UK at ~8x P/E and Macy's in US at ~18x P/E. I observe that the 1212 HK valuations has been de-rating across a past number of years, after being bidded up to as high as 20+x P/E and appears that it might eventually settle at a more resonable level.

Conclusion
I will be looking for a price level that grossly over-compensate me for the risks, especially those on the macroeconomic front. If the right price level can be found, 1212 HK will be interesting for the patient investor who gets paid a 4% dividend yield, while owning a piece of a well run company backed by a strong balance sheet that may allow for growth through acquisitions and which could potentially benefit from the long term China growth story (if you believe in that).

N.B. The analysis here is simplified and in no part constiute a buy/hold/sell recommendation. Readers should do their own analysis and make their own decisions. Caveat emptor.

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