Monday, June 15, 2020

Why I think Link Reit (HKG: 0823) is severely undervalued


The protests hit Hong Kong to usher in a low key traditional new year celebration, with many locals looking forward to a better 2020. While many are hoping that city will turn a corner, it’s been unfortunately hit by the Coronavirus. As the virus began to abate, the protests started gaining momentum again. Since mid-2019, many mainland tourists and foreigners have largely avoided travelling to HK, and even travel insurance companies started imposing exclusion for injuries sustained during the protests (even if you are a victim).

Hong Kong shares naturally took a beating, including Reits with exposure to Hong Kong. Despite the doom and gloom, I think there are still some bright spots in the Hong Kong stock market. One of the Reits which I believe is resilient and has much growth potential is Link Reit.

Link Reit is one of the largest Reit by market Capitalization in Asia. Despite a drop from its peak at HKD 99.8 to current level of HKD 67.1 (price as of 12th June)  it’s market cap is HKD 138 bil (SGD 24.8 bil).  In Singapore, the largest market cap Reit is Capitaland Mall Trust, with a market cap of (only) SGD7.3bil.



Some history of Link Reit

Link Reit’s properties was formerly own by Hong Kong housing authority, which consisted of shopping malls, carparks, wet markets and welfare centres. Most of the units are located near housing estate, serving the poorest, and elderly people with disabilities. Government then made the move in 2005 to privatize and list in the stock market. Since it was privatized, it was managed in a ‘business school fashion’, with the cash generated from housing properties to venture into commercial properties, and undergoing asset enhancement works and sending rental price soaring. This drove out cheap family run shops, and less business opportunity for lower income people who cannot afford the rent.

Hence housing estates termed Link Reit as a ‘Blood Sucker’, ‘Corporate Monster’ and the ‘ugly face of Capitalism’. The rental increase has been an increasing concern that the matter was brought to Carrie Lam to propose capping rental increase in Link Reit.

Despite the unhappiness among residents, Link Reit has done well for shareholders and outperforming Hang Seng Index. Unfortunately, it has given most of that back since the onset of protests.

However, I felt that the decline in Link Reit price is overdone and below are some of the points on why I think it is undervalued.

Here’s why.



Suburban Malls located in heartland Areas

Earlier this month, Link Reit announced its full year results ending Mar 2020. Despite the protests and Coronavirus lockdown, Link Reit achieved a revenue growth of 7% year on year and managed to increase its distributable Income by 4.23%  It’s occupancy rate for Hong Kong properties stands at 96.5% and 97.8% for mainland China property.

Link Reit Malls are mainly situated in suburban areas close to residential properties, hence it’s properties are less affected by disruptions or roadblocks caused by the protesters, as compared to shopping malls in central HK. Even as protests continues, life will still go for Hong Kongers. Residents will continue with their daily life shopping for groceries, necessities and ordering food.

Here’s the breakdown of it’s Trade Mix.



From the chart, its Food Related Trades: Food & Beverage, Supermarket & Foodstuff and Market/Cooked Food stalls account for 64.1% of the total portfolio as of 31st March 2020. With the bulk of it’s rent deriving from food and retail, it’s earnings should remain resilient despite the ongoing economic challenge.  Although Food & Beverage suffered a dip in rental tenant, its drop of 3.4% in sales growth was caused by social distancing measures in Hong Kong and China during the lockdown period rather than the HK protests.


In FY2019 ending September, Food & Beverage manage to register a growth of 2.1% Year on Year in growth in gross sales psf despite the ongoing protests. This shows that the protests have minimal impact on F&B sector. Management has also said in the results briefing on 1st June that things are slowly returning to normal. F&B, especially fast food outlets are experiencing a positive surge in the takeaway orders. As for retail stores selling discretionary goods, online orders help to make up for the decrease in footfall. The same is happening in China as well. 

Hence, should the economic situations and protests worsens, the overall retail portfolio stays resilient with trade related tenants accounting for 64.1% of retail portfolio’s Revenue.

Leverage within ‘A’ Rating

Since the start of the year, many Reits got a credit rating downgrade due Coronavirus, especially Hospitality and retail sector. This is especially true in Hong Kong.

Whereas for Link Reit, they managed to maintained their credit rating. In general, the better the credit rating, the lower the costs of debt.



To qualify as a reit, a company must have a bulk of assets & income related to real estates distributes 90% of the taxable income to shareholders. Hence Reit tend to hold lesser cash reserves and dependant on raising of cash in order to fund property acquisition. Cost of Capital is important is important to Reit, especially it comes to debt financing. It is the 2nd cheapest option after funding via retained cashflow. The formula for REIT’s cost of capital is Total Interest Expense/ Total Debt.

With its sound financial position, and cash balance of HK$ 7.8b, it’s average costs of debt stands at 2.94%. Recently, it managed to issue green bonds at an interest of 2.875%, rated A2 and A by Moody & S&P respectively yet purchase HK$2.8bil investment grade bonds of BBB+ on average, yielding 3.5%, benefitting from the spread in interest rate. This is done so to manage surplus cash and enhance returns to shareholders.

Hence under challenging times, Link Reit is well positioned to acquire more properties with lower cost of debt. It’s low gearing also gives Link Reit ample room to take on more debt and acquire properties under distress during market downturn.

Pipeline of Cashflow generating properties & Good AEIs to come

Link Reit also seeks to strengthen it’s portfolio through Asset Enhancement Initiatives. Since IPO till date, it has completed 85 enhancement projects. Generally Retail Reits tend to benefit from AEI as it unlocks the potential value of the mall by enhancing the retail environment and strengthen its appeal to shoppers.  

Being one of the largest Reit has it’s advantages. It has the financial clout to acquire more properties with better terms and favourable deals. Reits of such size also has ability to undergo more AEI without impacting its DPU significantly. For instance, a Reit consisting 10 properties undergoing AEI for two shopping malls will have greater impact on its overall on its NPI compared to Reit with having 132 properties.

Currently it also has pipeline of 23 AEI projects, with 19 projects under planning which will improve its DPU once completed. 

Valuation

Unlike the size of Champion Reit or Mapletree NAC Trust , Link Reit has a portfolio of 131 properties hence, I am unable to analyse individual properties in depth. I will be valuing based on 3 stage dividend discount model.

It is interesting to note that the management has been actively conducting share buybacks and cancelled the shares prior to the financial year end, a positive sign to investors which signals that it not only has sufficient funds to acquire properties, but positive outlook on the company’s future prospect. It's different from the buyback seen in SGX, where management conduct buyback shares but only held as treasury shares and to be issued to management for share vesting purposes or when stock options are exercised.






As management highlighted that retaining tenants is the key over increase in rental, I will assume a zero revenue growth from Mar 2020-2022, followed by a growth of 7% growth for the next 5 years 2022-2027 and terminal growth rate of 2%.

The average YoY drop in unit since 2015 is 2.13%. For units in issue, I will assume a 1.9% YoY decrease


NPI Margin
Although the average NPI margin is 74.9%, I am inclined to use NPI margin of 76% throughout because FY2018 results onwards shown a NPI margin above 76% and it’s improving year on year. Hence NPI Margin= 76%

Ratio of Distributable Income/NPI
Ratio of Distributable Income/NPI is fairly stable at low 0.70 range. I shall use the average of 0.73.

Discount Rate
Discount Rate= E(R)= Rf + β (Rm - Rf )
= 0.543+ 0.6 ( 5.43 – 0.543)
=3.4752.

According to CAPM, Link Reit has a low discount rate attributed by its low beta.

I will be more conservative and assume a discount rate of 5%.



Summing up all present values = 2.8+2.7+2.8+2.9+3.1+3.2+3.3+116.4= HK$ 137.3

If one holds a pessimistic view on Hong Kong's future after 2047, and Chinese government officially takes away all HK properties and Link Reit cease to exist.

We can find its intrinisic value by calculating perpetuity cashflow from 2047 onwards and discounting it to present value.


Hence, intrinic value of Link Reit= 137.3-64 = HK$ 73.3. It's still undervalued even with such conservative standards.

Anyway, my belief is that Chinese government will want to maintain Hong Kong's 'One Country, Two Systems' framework beyond 2047. I think there are many reasons to do so, one of which is HK's status as a gateway for global capital, benefitting Chinese companies listing in HKSE to raise funds. 
Also most of the properties owned by Link Reit have a leasehold of 50 years from 2005-2009 onwards, hence, it's very likely that Link Reit continue to exist beyond 2047.

There are many many more positive points on Link Reit which I did not touch on, as well as other commercial properties and carpark which it owns. As spoken in my previous posts, I would like to maintain the momentum in blogging. The key is to blog consistently and not to break the chain, rather than to blog a very long post.


What are your thoughts on Link Reit? Do you think current price is undervalued?

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4 comments:

  1. Hi, thanks for the brief yet insightful sharing. I would like to point out that CAPM return should be using expected return and not actual return. With the current uncertainties in the economy, the expected return would be much higher perhaps around 8-9% (http://www.market-risk-premia.com/hk.html). Would it be possible to analyse the sensitivity of the discount rate? Thank you/

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    Replies
    1. Hi Thunderskain,

      Sorry for the delayed response. But with the current low interest rate, a lower discount rate is justifiable too and HK index hasn't been great the past few years, hence that the lower market risk premium. Thanks for the link though.

      Thanks for the feedback, will try to the sesnsitivity analysis on discount rate when I have the time. Will update you!
      Meanwhile stay safe!

      Delete
  2. Very good analysis. Thank you

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