Sun Hung Kai & Co. Ltd. (SHGKY, Financial) (HKSE:00086, Financial), a $1.42 billion Hong Kong-based investment and finance firm, delivered its fiscal 2016 results in April. The company reported disappointing results with a 16% revenue decline to 3.5 billion Hong Kong dollars ($449.06 million) and 71.5% profit decline to HK$1.1 billion— a 32% margin compared to a 93% margin the year prior.
As observed, Sun Hung Kai experienced lower revenue secondary to an 18% decline in interest income (1). In addition, the company recorded higher overall profits in the past year because of a HK$3.2 billion recognition brought by discontinued operations. Excluding this one-time gain would lift the company's bottom line by more than half.
Executive Chairman Lee Seng Huang commented on the company's performance, saying its businesses are well positioned for the future.
“During the year, we have continued to increase our investment in loan businesses. The Mortgage Loan business operated under Sun Hung Kai Credit provides tailor-made funding solutions to home owners and investors in Hong Kong. It is already amongst the top three non-bank institutions for loan origination in this market segment.
Critical to this strategy, we continue to maintain a prudent and flexible balance sheet, with a net debtto-equity ratio of 20.3%.” (2)
Total return
Sung Hung Kai's ADR shares have fallen in the past year, with 26% total losses handed to its shareholders compared to S&P 500’s 18% total gains (Morningstar). Interestingly, the company-listed Hong Kong shares actually provided 17.4% total gains—markedly inverse of its ADR shares.
Valuations
Sun Hung Kai is undervalued compared to its peers. According to GuruFocus data, the company has a trailing price-earnings (P/E) ratio of 8.9 times versus the industry median of 12.7 times, a price-book (P/B) ratio 0.5 times versus the industry median of 1 and a price-sales (P/S) ratio of 2.8 times versus 6.5 times.
The company has a trailing dividend yield of 5.11% with a 51.5% payout ratio (Reuters).
Average 2017 sales and EPS expectations indicated forward multiples of 2.5 times and 9.1 times.
Sun Hung Kai
According to filings, Sun Hung Kai is an investment and finance firm with a focus on Greater China.
Since its founding in 1969, Sun Hung Kai has owned and operated market-leading businesses in financial services, striving to generate long-term capital growth for its shareholders.
The company invests across a diverse yet complementary portfolio of investment and finance businesses. Through online platforms as well as an extensive branch and office network across Hong Kong and mainland China, the finance business provides funding solutions to individuals, small businesses and corporations.
In addition, Sun Hung Kai is a major shareholder of leading consumer finance firm United Asia Finance Ltd. and a substantial shareholder of Sun Hung Kai Financial Group Ltd.
In 2016, the company generated 72% of its revenue in Hong Kong, 27% in mainland China and the rest in other countries.
The mainland China business has fallen significantly, about 44%, from its 2015 revenue figures. According to Sun Hung Kai, its United Asia Finance has implemented a strategic restructuring of its mainland China business in the wake of an economic downturn. As a result, it has continued to recover with good momentum.
Sun Hung Kai has five segments: Financial Services, Consumer Finance, Mortgage Loans, Principal Investments and Group Management and Support.
Financial services
This segment includes the company’s stakes in various financial services companies, including 30% ownership of Sun Hung Kai Financial and a 40% equity interest in LSS Financial Leasing (Shanghai) Co. Ltd.
In 2016, sales in financial services fell 20%, contributing just 0.1% of total unadjusted company sales. Nonetheless, financial services has actually been generating a good amount (about 12%) of total profit before taxation brought by Sun Hung Kai’s various interests.
Profit before taxation for the division improved 62% in the recent fiscal year.
Consumer finance
United Asia Finance Limited, a 58% indirectly owned subsidiary, operates Sun Hung Kai’s consumer finance business through online platforms and an extensive branch network in Hong Kong and mainland China. It primarily offers unsecured loans to individual consumers and small businesses.
Revenue decreased 18% due to the decline in the mainland China loan portfolio, having generated HK$3 billion and a pretax margin of 24% compared to 16% the year prior.
According to Sun Hung Kai, consumer finance’s profitability increased because of the much improved credit quality from the mainland China business.
Key operating data for consumer finance
1) The gross loan balance for the division fell 10% to HK$8.6 billion, having an average balance of HK$45,202 per loan.
2) Total returns for these loans in 2016 were lower at 33.4% compared to 34.2% in 2015.
3) The charge-off ratio*, meanwhile, was 10% in 2016 compared to 11.4% in 2015. As observed, the company has far more charge-offs in mainland China at 21.2% compared to 5.6% in Hong Kong.
*Experian definition: When an account displays a status of “charge-off,” it means the account is closed to future use, although the debt is still owed. The credit grantor may continue to report the past due amount and the balance owed. If you pay the account, the status will reflect as a “paid charge-off.”
4) Impairment allowance at the end of the year (which is calculated based on the historical charge-off rates and loan growth amount) was HK$906.3 million compared to HK$949 million in 2015. Albeit 5% lower, the ratio to gross loans ended higher at 10.6% in 2016 versus 9.9% the year before.
5) Past due but unimpaired loans consisted of a 12.5% net loan balance in 2016 compared to 15.5% in 2015.
Mortgage loans
The 86% owned subsidiary Sun Hung Kai Credit Ltd. operates under the mortgage loan segment. The subsidiary began operating in October 2015, providing mortgage services and funding solutions to home owners and property investors in Hong Kong.
In its first full year of operation, sales in mortgage loans increased to HK$55.7 million from HK$2.9 million the year prior. The division also generated a pretax profit of HK$1.8 million (3.2% margin) compared to HK$8.3 million in losses the same period the year before.
Further, total outstanding mortgage loans nearly tripled since the division began its operations to HK$613 million while total bad and doubtful debts also had a similar figure at almost the same rate—2.5 times the year prior at HK$3 million—0.49% of total loans compared to 0.56% in 2015.
Principal investments
According to filings, Sun Hung Kai’s principal investment portfolio invests across public and private investments, in credit and equity opportunities as well as real estate, with an aim of achieving attractive, risk-adjusted investment returns over the medium to long term. The segment’s subportfolio presentation has been reorganized based on these asset classes: equities, debt and fixed income and real estate.
In 2016, revenue in principal investments fell 7.8% to HK$405.9 million—11.6% of total unadjusted sales, and delivered a profit before tax margin of 116.4% compared to 104.7% the year prior.
In review, Sun Hung Kai maintains fewer costs in operating this division, resulting in heightened profitability. Nonetheless, the company’s principal investments generated an overall return (return on average value) of 10.1% compared to 11.6% in 2015.
These returns from Sun Hung Kai’s equity, debt and fixed income and real estate investments were far superior to the overall returns of the Hang Seng Index ETF of 3.8% in 2016 alone (Morningstar).
Sales and profits
In the past three fiscal years, Sun Hung Kai had average sales decline of 8.5%, profit growth of 1.8% and a profit margin of 50% (Morningstar).
Cash, debt and book value
As of December 2016, the company had HK$5.19 billion in cash and cash equivalents and HK$10.1 billion in borrowings with a leverage ratio of 0.56 times compared to 0.55 times in 2015 (Morningstar).
Ten percent of its HK$32.6 billion in assets were labeled as goodwill and intangibles, while having a book value of HK$18 billion—the same as the previous year.
Cash flow
In fiscal 2016, Sun Hung Kai’s cash flow from operations fell 61% to HK$623 million due to lower overall profits during the year. Capital expenditures were HK$34 million, leaving the company with HK$589 million compared to HK$1.53 billion the year before.
In addition, Sun Hung Kai allocated 127% of its free cash flow to dividends and share repurchases. On average, the company handed out 87% of its free cash flow in shareholder payouts over the past two fiscal years. Also, Sun Hung Kai took in HK$138 million in borrowings, net repayments and other borrowings.
Conclusion
As observed, Sun Hung Kai’s overall business failed to grow in 2016. If not for its interests in its namesake subsidiaries among others, the investment firm would have delivered poor profitability as well. Nonetheless, the company generated more than half of its growth through profits before taxation,having ignored one-time additions.
Being engaged in finance, the company has an acceptable (0.6 times) leverage ratio while carrying a limited amount of blue sky elements, goodwill and intangible assets. In addition, Sun Hung Kai was able to allocate a good amount of its cash flow to dividends and repurchases.
Applying a 30% discount to Sun Hung Kai’s book value as of December 2016 would indicate a value of HK$12.7 billion—14.6% upside from its locally listed valuation of HK$11.1 billion. In the current exchange rate, this would indicate a value of $1.6 billion—or 18.5% upside from today’s total ADR valuation of $1.3 billion.
Notes
(1) Sung Hung Kai & Co Annual Filing: Interest income from financial assets is recognized on a time apportionment basis, taking into account the principal amounts outstanding and the effective interest applicable, which is the rate that discounts the estimated future cash flows through the expected life of the financial asset to that asset’s net carrying amount on initial recognition.
(2) Me: This is not the full message of the Executive Chairman. Please read the company’s Chairman Letter in its annual report.
Disclosure: I have no Sun Hung Kai ADR shares.
