What Is The Fair Price To Pay For CK Hutchison?

In the world of investing, there is no 'one size fits all' approach to analyse a security as every industry has different dynamics at play. The task at hand becomes more challenging when investors attempt to value conglomerates that have diverse businesses, each with unique characteristics, but are bundled and sold as a single package. CK Hutchison (HKEX.1), which we highlighted in our previous article, is one such example. With such diverse segments as port operations, retail, infrastructure, energy and telecommunications, putting a value on CK Hutchison is no straightforward feat. In such cases, the sum-of-the-parts valuation method (SOTP) will come in handy to give investors a rough gauge of a conglomerate's valuation. We illustrate in this article how investors can utilise the SOTP valuation method, using CK Hutchison as an example.

Sum-Of-The-Parts Valuation Method

The SOTP valuation method, also known as break-up value analysis, is one of the most commonly used methodology to value a conglomerate with unrelated business segments. It involves breaking up a conglomerate into its individual segments and valuing each as though they were standalone businesses. The idea behind SOTP is that businesses with unique characteristics may require varying valuation approaches. As such, the SOTP can be seen as a combination of various conventional valuation methodologies, with the choice of valuation method for each business segment a function of industry dynamics and individual company characteristics. The values of the individual parts are then summed to derive the enterprise value of the conglomerate as a whole.

As the enterprise value represents the value to all contributors of capital, including bondholders and common shareholders, it should then be adjusted for any debt or preference shares that the firm may have issued. Non-controlling interests are subtracted, while cash and marketable securities are added to the enterprise value to arrive at the equity value of the conglomerate, which can then be compared to the current market capitalisation to assess its attractiveness. In cases where the various business segments are either unrelated or have limited synergies, the use of a conglomerate discount may be warranted.

To help investors better understand SOTP, we will apply the SOTP on CK Hutchison.

Port Operations

With interests in 48 ports across 25 countries, CK Hutchison is the world's leading port operator. It has an 80% ownership in the Hutchison Ports group of companies, as well as a 30.07% interest in Singapore-listed Hutchison Port Holdings Trust (HPHT). Collectively, the two subsidiaries handled a total of 81.4 million twenty-four equivalent units of container throughput in 2016.

Given that HPHT has been paying out most of its distributable income to its unitholders, distributions per unit (DPU) is a critical share price driver and the dividend discount model can be used to value the business trust. Assuming a discount rate of 6.0% (calculated using the capital asset pricing model) and a constant no-growth DPU of HKD 0.213, the simplified model yields an estimated target price of HKD 3.56 (Chart 1). With an estimated 8.7 billion units outstanding, HPHT's equity value works out to be about HKD 31 billion, of which HKD 9.3 billion is attributable to CK Hutchison's 30.07% ownership interest in the business trust.

Chart 1: Intrinsic Value Of Hutchison Port Holdings Trust

While the Hutchison Ports group of companies is unlisted, we can estimate its value using data from a prior transaction, in which PSA International acquired a 20% stake in Hutchison Port Holdings for a total consideration of USD 4.4 billion in 2006, representing an estimated 16X EBIT. As uncertainty continues to surround global trade prospects, EBIT is also assumed to remain unchanged from 2016 at HKD 5.7 billion. With these inputs, the value of CK Hutchison's 80% stake in Hutchison Port Holdings is estimated to be HKD 73.5 billion.

Retail

CK Hutchison's retail subsidiary, A.S. Watson Group, is the largest retailer of health and beauty products globally, operating some 13,300 retail outlets across Asia and Europe, under brands such as Watsons, ParknShop supermarkets, and Fortress electrical appliances stores.

Similar to the Hutchison Ports group of companies, A.S. Watson Group is unlisted and has once sold a part of its stake to an external investor. We can thus estimate its value using data from the prior transaction, in which Temasek Holdings acquired a 25% stake in the company for a total consideration of USD 23 billion in 2014. The deal was priced at about 15X EBIT. We assume a 5% EBIT growth rate, as A.S. Watson's strength in its health and beauty segment is likely to be offset by the drag from its supermarkets and electrical appliance stores, which has been struggling amidst a challenging operating environment. Using these assumptions and inputs, CK Hutchison's 75% stake in A.S. Watson is worth about HKD 142.4 billion.

Infrastructure

CK Hutchison's infrastructure segment includes its 75.67% stake in Cheung Kong Infrastructure (HKEX.1038). As mentioned in this article, its underlying assets tend to generate stable and consistent cash flows. Thus, the use of either an earnings-based or a cash flow-based valuation methods to value the company are both suitable. We opted to use the price-to-earnings (PE) ratio in our calculations. Its estimated earnings per share of HKD 4.09 and forward PE ratio of 16.1X implies an equity value of HKD 171.2 billion. Adjusting for net debt and preference shares yields an enterprise value of HKD 185.8 billion, of which HKD 140.6 billion is attributable to CK Hutchison's 75.67% stake.

The segment also includes CK Hutchison's six co-owned joint ventures, including Northumbrian Water, Park'N Fly, Australian Gas Networks, Dutch Enviro Energy, Wales & West Utilities and UK Rails. The value of these joint ventures were calculated using the enterprise value at time of privatisation, when they were acquired by CK Hutchison. The total enterprise value for these joint ventures were estimated to be HKD 99.3 billion.

Energy

CK Hutchison's energy division consists of its 40.18% ownership interest in Husky Energy, one of Canada's largest integrated energy companies. Given that oil and gas companies typically take on high levels of debt, valuing Husky Energy using an enterprise value based multiple such as the EV/EBITDA will be suitable. The advantage of the EV/EBITDA over other commonly used multiples is that it is not affected by the capital structure of a company as enterprise value includes both debt and equity.

Based on consensus estimates, Husky Energy's EBITDA is projected to be HKD 21.3 billion this year. If we apply an EV/EBITDA multiple of 5.6X, calculated using the company's five-year historical average, to the company's forecasted 2017 EBITDA, Husky Energy's estimated enterprise value works out to be about HKD 119 billion. As Husky Energy is not consolidated into CK Hutchison, we adjusted this figure for net debt and preference shares to arrive at an equity value of HKD 91.5 billion. With an ownership interest of 40.18%, CK Hutchison's share in Husky Energy is worth approximately HKD 36.8 billion.

Telecommunications

Similar to the oil and gas industry, the valuation of telecommunications firms can be done using the EV/EBITDA multiple. The industry is generally capital intensive with high fixed costs, and companies usually borrow to fund their capital expenditures. As such, telecommunications companies are characterised by relatively high levels of debt financing. With a huge fixed asset base, their depreciation expenses also tend to be lofty. The use of the EV/EBITDA multiple to value telecommunications companies, therefore, appears justified as it is not affected by the capital structure of a company. By excluding non-cash expenses and financing costs, EBITDA is also a fairer gauge of a firm's underlying profitability.

The telecommunications division of CK Hutchison is made up of its 3 Group businesses in Europe; a 66.09% interest in Hong Kong-listed Hutchison Telecommunications Hong Kong Holdings (HKEX.215), providing mobile services in Hong Kong and Macau; Hutchison Asia Telecommunications, which holds interests in the group's mobile operations in Indonesia, Vietnam and Sri Lanka; as well as an 88.48% ownership in Australia-listed Hutchison Telecommunication Australia.

For listed companies, we calculated their individual enterprise value using consensus EBITDA estimates and their respective five-year average EV/EBITDA multiples. As there are no consensus estimates available for Hutchison Telecommunication Australia, the market capitalisation implied enterprise value was used in our calculations. The value of the unlisted subsidiaries are calculated using an assumed EBITDA growth rate of 20%, not unreasonable given that 3 Group Europe's recent acquisition in Italy is expected to be a future earnings driver, while Hutchison Asia Telecommunications is also expected to continue its strong earnings momentum as it expands its market share in developing Asia. The industry average EV/EBITDA multiples in their respective geographical markets were also used in our calculations (Table 1).

Table 1: Total Enterprise Value Of CK Hutchison's Telecoms Segment

Conglomerate Discount

Closely related to the SOTP valuation method is the concept of a conglomerate discount, which refers to the phenomenon that conglomerates typically trade a price that is below the combined value of its separate entities. The prevailing idea behind the conglomerate discount is that the diverse business segments of a conglomerate typically have limited synergies, resulting in inefficiencies that may not maximise overall shareholder value. Moreover, investors who are looking for more focused exposure in certain sectors will think twice before plonking their money down on the conglomerate stock, even though they may be interested in some of the individual business segments, as the investment will come along with undesired exposure in other sectors.

The degree to which a conglomerate receives a discount can vary, and it usually depends on the relatedness of its individual businesses. Since the major reorganisation in 2015, CK Hutchison has been trading at an average of -5% discount to its book value. At its lowest, however, the conglomerate's stock traded at close to a -20% discount to book value. Given the complexity of SOTP, there is a greater margin for errors in our assumptions and analyses, and to err on the side of caution, we used a -20% conglomerate discount in our calculations.

Summing The Parts Up

The last step in this analysis is to sum up the enterprise values of the individual business segments. CK Hutchison's total enterprise value, from our analysis thus far, works out to be HKD 865.1 billion. This figure, however, includes the value to debtholders and preference shareholders, and must be adjusted for net debt and preference shares. We apply a -20% conglomerate discount to arrive at an equity value of HKD 451.2 billion. With 3.9 billion shares outstanding, CK Hutchison's intrinsic value is about HKD 115.69 per share, which represents a potential upside of about 17% based on its last traded price of HKD 98.90 as of 14 June 2017.

Table 2: Calculation Of CK Hutchison's Intrinsic Value Using SOTP

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.

The Research Team is part of iFAST Financial Pte Ltd.