CDL is trading at steep discount to NAV, but its ROEs have declined significantly over the past decade

 

CITY Developments (CDL) has lost about 8 per cent of its market value since revealing last week that there were bitter divisions within its board in relation to its investment in Chinese real estate firm Sincere Property Group (SPG) and its management of Millennium & Copthorne Hotels (M& C).

 

Its shares closed at S$7.04 on Friday, which is just over 0.6 times the company' s net asset value (NAV) as at June 30 of S$11.66 per share. This is even lower than the trough price-to-book valuations at which the stock traded during the depths of the Global Financial Crisis (GFC), which some analysts see as sufficient justification to remain invested.

 

Yet, CDL' s investment fundamentals were quite different a decade ago. In particular, the company was generating much higher returns on equity (ROEs) than it is now.

 

CDL' s ROE jumped sharply to 13.9 per cent in 2007, and then remained in double-digit territory for four more years, all the way through the turmoil of the GFC. Although the stock whipsawed during the crisis period, it was ultimately supported by an elevated level of profitability.

 

Things have changed since then. CDL' s ROE slipped to 9.3 per cent in 2012, from 11.7 per cent in 2011. Its ROE subsequently trended lower and lower, to just 5.4 per cent in 2019.

 

One likely reason for CDL' s falling ROE is that its core property development business has become much tougher over the years.

 

The government has displayed unwavering determination to stamp out any sign of speculative activity in the property sector. From late 2009 to early 2014, several rounds of " cooling measures" were rolled out in order to tame the market - including increasingly punitive stamp duties and caps on mortgage lending.

 

In 2018, following a surge in collective sale transactions, the government introduced yet another round of cooling measures, which drew howls of protest from property developers.

 

While it appears that private property sales are now headed into another upturn, it would probably be unwise for investors to bet that the property market will develop sufficient momentum to drive CDL' s ROEs back to the double-digit levels of 2007-2011 without the government slamming on the brakes again.

 

If shares in CDL are to narrow their discount to book value, the company needs to find other ways to lift its profitability - perhaps by getting into new markets or generating better returns from its investment properties.

 

This is perhaps why the market has reacted so negatively to the revelation last week of disagreements within CDL' s board about SPG and M& C.

 

Big bet on M& C, SPG

 

CDL took the London-listed M& C private last year, following a cash offer at 685 pence per share that valued the hotel company at £ 2.23 billion (S$3.95 billion). CDL already owned 65.2 per cent of M& C before the offer. CDL had previously attempted to take M& C private at 620 pence per share, but its offer was rebuffed by minority investors.

 

With M& C within its fold, CDL said in its most recent annual report that it plans to pursue initiatives to maximise shareholder value. " These include controlling and reducing operating costs acutely leveraging the group' s global network, resources and real estate capabilities to refurbish assets for enhanced growth - especially those with conference facilities repositioning underperforming assets and exploring the development of unutilised land."

 

With the fallout from Covid-19, however, CDL' s hotels business has been a major drag on its profitability this year.

 

For H1 2020, CDL reported a 32.8 per cent year-on-year decline in revenue to S$1,072.9 million. Its earnings for the half-year period came in at just S$3.1 million, versus S$362 million for H1 2019.

 

CDL reported pre-tax profit of S$13.8 million for H1 2020, down from S$490.3 million for the same period in 2019. The group' s hotel operations recorded a pre-tax loss of S$208.2 million, which included S$33.9 million of impairment losses made in view of the pandemic.

 

It was also last year that CDL announced its initial plan to invest in SPG. In May 2019, CDL said it would stump up 5.5 billion yuan in equity and interest bearing loans to acquire a 24 per cent stake.

 

But CDL only went as far as extending a loan of 2.75 billion yuan to SPG before the deal was renegotiated.

 

CDL said in April that it had struck a new deal that would see it acquire a more than 51 per cent stake in SPG for an initial investment of 4.4 billion yuan, part of which will be used to repay the 2.75 billion yuan loan.

 

CDL will also be granted a call option to purchase an additional 9 per cent effective interest in SPG for 0.77 billion yuan.

 

CDL' s stake in SPG will be held through an offshore holding company in which SPG' s chairman and founder Wu Xu will retain a stake, giving him an effective 20 per cent interest in SPG.

 

This revised deal is based on an agreed valuation of 8.6 billion yuan for SPG, which is almost 50 per cent below SPG' s unaudited NAV as at Dec 31 of 16.48 billion yuan.

 

Through SPG, CDL said it would gain a presence in 18 cities in China, a portfolio of 27 investment properties, a landbank of 9.2 million square metres of gross floor area, and access to SPG' s talent pool of over 2,000 employees.

 

CDL did warn, however, that SPG faces near-term " challenges and uncertainties" caused by the Covid-19 pandemic.

 

Alternative plan?

 

Last week, CDL outlined the full extent of its current exposure to SPG. Besides the 51 per cent equity investment in SPG of 4.4 billion yuan, CDL had subscribed for US$230 million in bonds issued by SPG and extended a working capital loan of 650 million yuan.

 

CDL had also provided a liquidity support undertaking totalling 1.5 billion yuan relating to bonds issued by SPG that mature on Oct 26, 2020, and a 1.5 billion yuan corporate guarantee in relation to an external bank loan.

 

CDL calculates its total current exposure to SPG to be S$1.9 billion.

 

CDL said this continuing financial support for SPG and concerns about the management of M& C were among the reasons that Kwek Leng Peck had decided to resign from its board.

 

Mr Kwek' s decision has potentially significant implications for ordinary shareholders of CDL. Firstly, he clearly has a great deal of knowledge and insight about CDL' s business, having been a member of its board since 1987.

 

More importantly, he is a senior member of the family that ultimately controls CDL. He is a cousin of CDL' s executive chairman Kwek Leng Beng, and an uncle of CDL' s CEO Sherman Kwek. Even after his exit from the board, he could conceivably continue to influence its thinking on SPG and M& C.

 

Could CDL ultimately decide that it is on the wrong track with SPG and M& C? What else can it do to lift its sagging ROE? If there is no credible plan to improve its underlying profitability, what is CDL' s future as a public-listed company? Should it liquidate some of its key assets and go private?

 

During the 10-year period up to end-2019, before Covid-19 emerged, shares in CDL delivered a total return of just over 11 per cent (with dividends reinvested). By comparison, the Straits Times Index delivered a total return of more than 54 per cent over the same period.

 

Unless CDL can confidently offer investors the prospect of significantly better returns that it has generated over the past decade, it seems unlikely that the steep discount to NAV at which its shares trade will narrow much.

 

CDL' s top executives and independent directors could face a testing time in the weeks and months ahead as they engage the company' s majority and minority shareholders on the appropriate way forward.

 

Kwek Leng Peck, cousin to City Developments&rsquo (CDL) executive chairman Kwek Leng Beng and uncle to its group CEO Sherman Kwek, has resigned as a non-executive director of the property group from Oct 19. The company&rsquo s announcement raised speculations that Leng Peck resigned in protest. 

 

He is said to have disagreed with CDL&rsquo s investment in Sincere Property Group, including the continuing of financial support totalling $1.9 billion to the China-based developer. In addition, Leng Peck has &ldquo reservations&rdquo with CDL&rsquo s approach in the management of its hospitality unit, Millennium & Copthorne Hotels (M& C).

 

First appointed to the board in August 1987, Leng Peck holds directorships in M& C, Hong Leong Investment Holdings (HLIH is the major shareholder of CDL) and several related companies under Hong Leong Group such as Hong Leong Asia, Hong Leong Finance, Tasek Corporation and China Yuchai International. According to CDL&rsquo s FY2019 annual report, Leng Peck owns a direct stake of 0.005%, while HLIH is currently CDL&rsquo s largest shareholder with a stake of 48.552%.

 

On Oct 21, CDL disclosed that it has invested a total of $1.9 billion in Sincere, comprising of an equity stake of 51.01% worth RMB4.4 billion ($894.9 million), US$230 million ($311.8 million) in bonds issued by Sincere, a working capital loan of RMB650 million, liquidity support of RMB1.5 billion relating to Sincere&rsquo s bonds maturing on Oct 26 and a corporate guarantee of RMB1.5 billion relating to Sincere&rsquo s external loan.

 

In April 2020, CDL acquired a 51% stake in Sincere for the equivalent of $880 million which was then seen as a 50% discount to Sincere&rsquo s NAV at the time. In August, CDL announced that negative goodwill and fair value of the call option to further acquire 9% in Sincere totalling $50.9 million was recognised in 1H2020. The group also accounted for a post-acquisition share of loss of Sincere due to financing and marketing costs incurred by Sincere, and depreciation of Sincere&rsquo s investment properties due to alignment of accounting policy.

 

&ldquo CDL subsequently wrote down Sincere&rsquo s investment property values in August, resulting in a 42% decline in [the latter&rsquo s] NAV. We believe valuation and execution concerns in Sincere are under the spotlight once again,&rdquo Bank of America says in a recent report. 

 

&ldquo We do not think [Kwek Leng Peck&rsquo s] concerns are entirely new and were already well-flagged, particularly regarding M& C (30% of CDL&rsquo s revalued NAV), whereby most hoteliers are facing tough operational issues given Covid-19. We think more assistance to Sincere (7% of RNAV) highlights its liquidity issues,&rdquo the report adds.

 

Also on Oct 21, CDL announced its board of directors is in the process of identifying and appointing an External Financial Advisor to assist with further evaluation and review of the group&rsquo s investment in Sincere including sales of investment properties.

 

During a results briefing in August, CDL CEO Sherman had said: &ldquo [Of] Sincere&rsquo s investment properties a fairly large chunk are in retail and hospitality, and still suffering from the aftermath of Covid. We have more than 10 assets on the list to be divested. It will be something that will likely take time.&rdquo

&ldquo Having injected $1.9 billion into Sincere, we doubt it would walk away. Hence the financial advisors&rsquo evaluation, pace of asset sales and residential sales momentum will be pivotal in Sincere&rsquo s refinancing ability. As of end FY2019, we estimate Sincere&rsquo s net debt at $7.3 billion,&rdquo Citi says in a note to clients.

 

&ldquo The question now is whether the board should continue to provide financial support to Sincere under the assumption the market would eventually recover, or push through divestments now and take a haircut on its investment. Either way, in our view, this may lead to a valuation drag,&rdquo says the Bank of America report.

 

For 1HFY2020, CDL reported Patmi of $3.1 million versus Patmi of $362 million in 1HFY2019. The decline in Patmi includes impairments for M& C and allowances for Sincere.

 

&ldquo This event leads us to revisit our assumptions. We lower our price objective by 13% to $8.70 on a 4% reduction to RNAV (on higher debt in Sincere) and a higher valuation discount of 40% (vs 35% previously), in line with historical downturns. 

 

A bear case of a complete write-down of its $1.9 billion investment implies an $2.10 per share hit on its valuation,&rdquo Bank of America calculates.

CDL last traded at $7, versus its NAV of $11.66 and RNAV of $16.61. CDL&rsquo s NAV is based on the book valuation of its properties where the company uses historical cost accounting. Its RNAV is based on the market valuation of its properties.

 

&ldquo We reiterate buy on valuation as we think the sell-down is overdone. A successful restructuring of Sincere could be a catalyst,&rdquo Bank of America adds.