Henderson Land has too many square feet
Hong Kong property developer Henderson Land Development has a peculiar problem: too much land. The company is the biggest agricultural land owner in the New Territories and owns millions of square feet of floor area in Hong Kong and the mainland.
Between 2008 and 2010, Henderson Land, which was bullish on the mainland property market, aggressively expanded its land bank there at what it considered to be cheap prices. It also bought a lot farmland in the New Territories in the expectation the area would be developed into towns. Its property inventories rose by more than 60 per cent in that period.
Property sales failed to keep pace, dropping from HK$11.1 billion in financial year 2008 to a low of HK$3.6 billion in 2010. The company as a result has a lot of property inventories on its books.
Roughly speaking, it would take Henderson Land eight years to use all its property inventories at the current rate it is selling developments. By comparison, Cheung Kong (Holdings) and Sun Hung Kai Properties (SHKP) would use all their land in more than three years, and New World Development would take 4½ years.
One might think a developer could never have too much property in Hong Kong. But the market discounts Henderson Land precisely because of its property excess.
Let's break this down.
Henderson Land's chairman Lee Shau-kee constantly reminds the market that the firm trades at a steep discount to its book value.
On the surface, Henderson Land's price-to-book ratio of around 0.7 times is in line with conglomerates with extensive property interests such as Cheung Kong, SHKP and New World Development, which are trading between 0.68 and 0.83, according to Bloomberg.
To recap, property companies are commonly valued using the price-to-book ratio, a comparison of the firm's equity value with its "book value", or the theoretical value of the firm if it goes into liquidation today. (See last week's column: "Cheap at twice the price".)
However, Henderson Land's price-to-book ratio is inflated by its huge 40 per cent stake in Hong Kong and China Gas, which accounts for more than half of its market value. The latter, which supplies gas in Hong Kong and various parts of the mainland, has a market capitalisation of more than HK$170 billion and trades at more than four times its book value.
The company also owns stakes in the listed firms Henderson Investment, Hong Kong Ferry and Miramar Hotels, which together with the investment in Hong Kong and China Gas, are worth a combined HK$72.6 billion.
Stripping out these assets, Henderson's property development business on its own is priced by the market at about 0.4 times book value, and about 5.2 times earnings.
One could perform a similar analysis for the company's fellow property conglomerates such as Cheung Kong, SHKP and New World Development by stripping out their non-property assets (Hutchison Whampoa and CK Life Sciences for Cheung Kong, SmarTone Telecommunications for SHKP and New World Department Store for New World Development), and see how Henderson stacks up against them (see table).
This offers a like-for-like comparison of the big developers' valuations, as we are excluding non-property businesses that might muddy the picture.
Based on this comparison, Henderson Land registers the second highest price/earnings ratio among its peers.
So why does this company look so cheap based on the price-to-book ratio?
Land is to property developers what inventory is to manufacturers. Too little of it and markets worry where profits are going to come from. For instance, Sino Land recently allayed investor concerns over its dwindling land bank after it bought two big pieces of land in Long Ping MTR West Rail Station and Tseung Kwan O Station jointly with K Wah International.
However, having too much land lying around is not necessarily a good thing either, as it involves significant opportunity costs. Developers only make more money when they are developing and selling properties. Idle land ties up capital - forgoing the opportunity to invest that money elsewhere - and incurs financing costs.
Based on the price/earnings ratios, it seems that the markets are pricing Henderson Land in line with its peers.
But its return on equity, depressed by non-income producing land bank, is the lowest among its peers.
Because it takes Henderson Land longer than its peers to realise profits on its property inventories, they are worth less - a dollar made tomorrow is worth less today one earned today.
Henderson's land excess is risky - property prices could drop - and there are concerns over its ability to ramp up property sales if the real estate market goes into decline.
Finally, in volatile markets, investors might not like taking a long view on Henderson Land's payoff potential. The land bank may turn out to be a shrewd investment; it may not.
All things considered it may be best to go with the developer that it rapidly turning over its property inventory and fully utilising today's sky-high real estate prices.