Hysan Development: Domestic Market Exposure Is A Negative Now

Summary

• Hysan Development is a pure play on the Hong Kong property rental market, and the company has been impacted by social unrest in 2019 and the coronavirus outbreak in 2020.
• Continued economic weakness for Hong Kong will be negative for both Hysan Development's retail and office segments, although the office property business is relatively more resilient.
• The company's strong balance sheet and steady dividend payout remain key positives for the stock.
• Hysan Development currently trades at 0.38 times P/B and offers a consensus forward FY2020 dividend yield of 5.1%.
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Elevator Pitch

I maintain my "Neutral" rating on Hong Kong-listed property company Hysan Development Company Limited (OTC:HYSNF) (OTCPK:HYSNY) [14:HK]. Hysan Development stands out from other Hong Kong-listed property developers and REITs with its balanced exposure between retail and office properties. However, Hysan Development suffers from a lack of geographical diversification with all of the company's investment properties located in its home market, at a time when Hong Kong is experiencing severe economic weakness.

With most of the current negatives priced into Hysan Development's share price considering its P/B valuation multiple, a "Neutral" rating is warranted.

This is an update of my initiation article on Hysan Development published on August 20, 2019. Hysan Development's share price has declined by approximately -18% from HK$34.55 as of August 19, 2019 to HK$28.20 as of March 2, 2020 since my initiation. Hysan Development currently trades at 0.38 times P/B, which represents a discount to the stock's historical five-year and 10-year P/B multiples of approximately 0.55 times and 0.63 times respectively. The stock traded as low as 0.32 times P/B during the 2008-2009 Global Financial Crisis. Hysan Development also offers a consensus forward FY2020 dividend yield of 5.1%.

Readers are advised to trade in Hysan Development shares listed on the Hong Kong Stock Exchange with the ticker 14:HK, where average daily trading value for the past three months exceeds $8 million and market capitalization is above $3.5 billion. Investors can invest in key Asian stock markets either using U.S. brokers with international coverage, such as Interactive Brokers, Fidelity, or Charles Schwab, or local brokers operating in their respective domestic markets.

Pure Play On Hong Kong Property Rental Market

Hysan Development derived approximately 48.0%, 44.6% and 7.4% of its FY2019 operating profit from the company's office, retail and residential properties respectively. In the company's FY2019 financial results presentation, Hysan Development emphasized that its balanced exposure between retail and office properties makes the company "more resilient to unexpected disruptions and impacts."

It is only true that Hysan Development is "more resilient" if there are specific events or factors that solely impact the retail property or office property in Hong Kong. Social unrest in 2019 and the current coronavirus outbreak in 2020 year-to-date have been negative for both the Hong Kong economy and Hysan Development.

Hong Kong experienced its first recession since the 2008-2009 Global Financial Crisis last year, which was largely attributable to the negative impact of protests and social unrest which started in the second half of 2019. Furthermore, tourist arrivals in Hong Kong also fell by -14.2% YoY to 3.2 million in 2019. The current coronavirus outbreak is expected to add to Hong Kong's woes. Average daily tourist arrivals in Hong Kong were approximately 3,000 in the first half of February 2020, compared with 100,000 for the month of January 2020. At the time of writing, Hong Kong had 100 (cumulative) confirmed cases of coronavirus infections and two deaths. Hong Kong's GDP declined by -1.2% for full-year 2019, and the Hong Kong government is forecasting a GDP growth rate in the range of between -1.5% and +0.5% for 2020, which implies that a second consecutive year of recession for Hong Kong can't be ruled out.

Almost all of Hysan Development's assets are located in Hong Kong, with the exception of certain financial investments and associate companies. Hysan Development's revenue from retail properties declined -13.1% YoY and -16.6% HoH (half-on-half) to HK$835 million in 2H2019. The office property business fared slightly better with 2H2019 segment revenue of HK$904 million representing a +4.1% YoY growth, but revenue from office properties still declined by -2.7% HoH.

In the subsequent sections of the article, I discuss the potential negative impact of the current coronavirus outbreak on Hysan Development's retail and office property segments.

Rent Concessions For Retail Segment To Hurt But Mitigated By Low Turnover Rent Component

At the company's FY2019 results briefing on February 20, 2020, Hysan Development disclosed that it is "offering a meaningful rent concession with reduction in basic rent in February and in March." This implies downside risks to retail rental income for Hysan Development in FY2020. There is a possibility that these rent concessions could be extended beyond March 2020, if the current coronavirus outbreak takes a longer-than-expected time to be contained.

Furthermore, potential negative rental reversions for FY2020 are another concern. Although Hysan Development achieved positive rental reversions for the retail property segment in FY2019, the company acknowledged that "it is not inconceivable to see some negatives" when a question on the retail rental reversion outlook in 2020 was asked at the recent earnings call. Approximately a quarter of Hysan Development's retail property leases in terms of area occupied is up for renewal in 2020.

Also, the occupancy cost ratio (total rent as a percentage of total retail sales) for Hysan Development's retail properties has increased from the high-teens in 1H2019 to 22%-23% in 2H2019. Hysan Development's overall retail portfolio occupancy rate was still high at 96% as of end-2019. Therefore, there are also downside risks to the retail property portfolio occupancy rate, if certain of the company's existing retail tenants choose to relocate to other cheaper locations upon lease expiry.

On the positive side of things, there are two key factors that could partly mitigate the negative impact of the current coronavirus outbreak on Hysan Development's retail property segment.

One key factor is that turnover rent (portion of rent that is variable with tenants' retail sales) is relatively low for Hysan Development, contributing only 2.0% and 4.9% of its retail portfolio revenue for 2H2019 and 1H2019 respectively. In contrast, retail property peers such as Champion Real Estate Investment Trust [2778:HK] and Wharf Real Estate Investment Company (OTCPK:WRFRF) [1997:HK] have turnover rent accounting for approximately a mid-to-high teens percentage of their total retail property revenue in 1H2019 based on my estimates.

Another key factor is that Hysan Development has been actively optimizing its tenant mix to counter structural trends such as e-commerce growth and the narrowing price differential between luxury and high-end products in Mainland China and Hong Kong. This has paid off in the form of positive rental reversions for the retail property segment in a difficult 2019 that was negatively impacted by social unrest. Hysan Development optimized its retail property portfolio with the addition of 35 new brands in 2019 to keep shoppers engaged, and 27 retail stores were renovated last year to improve the consumer shopping experience.

Hysan Development's Tenant Mix Optimization In FY2019

Source: Hysan Development's FY2019 Results Presentation Slides

Office Segment Relatively More Resilient But Watch Out For Expiring Leases And Industry Concentration

As highlighted above, Hysan Development's office property segment has performed much better than the retail property segment in 2H2019. Notably, the company achieved positive rental reversions in the mid-teens for the office property segment in FY2019. This is likely attributable to the fact that Hysan Development is a beneficiary of the emerging trend of decentralization where companies are relocating their offices from Central Hong Kong to relatively cheaper locations outside Central. Hysan Development's office properties are located in Hong Kong's Causeway Bay area.

Approximately 22% of Hysan Development's office property leases in terms of area occupied expires in 2020. If the Hong Kong economy continues to weaken for the rest of 2020, there is a risk that rental reversions for Hysan Development's office property segment narrow in FY2020 or even turn negative.

The downside risk for Hysan Development's office property rental reversions is limited by two key factors.

Firstly, a quarter of the expiring office leases in FY2020 has been already re-committed as of February 2020 with associated rental reversion still positive in the teens.

Secondly, the passing rent for the expiring office lease is approximately 4%-5% lower than the spot office rent in 2019. Assuming Hysan Development can renew the rest of the expiring office leases at 2019 spot rent levels, the company can still deliver a decent mid-single digit rental reversions in FY2020.

However, one also needs to watch out for tenant industry concentration. In terms of tenant mix, tenants from the banking & finance, professional & consulting and co-working industries accounted for 24%, 16% and 10% of Hysan Development's office property portfolio. Notably, companies in the banking & finance and co-working industries are perceived to be vulnerable in a prolonged economic recession.

Strong Balance Sheet And Steady Dividend Payout Are Key Positives

Hysan Development's financial position is relatively strong with a very low net debt-to-equity ratio of 4.1% as of end-2019, a net interest coverage ratio of 17.0 times for FY2019, and investment-grade credit ratings from all the three major credit rating agencies. Furthermore, refinancing risks and interest rate fluctuations are not key concerns for Hysan Development, given that the company has a long average debt maturity of 6.6 years, and 84% of the company's debt is on fixed rate terms.

In terms of dividends, Hysan Development paid out full-year FY2019 dividends amounting to HK$1.44 per share which was the same as FY2018 and represented a dividend payout ratio of 58%. For the past 15 years, Hysan Development has either maintained or increased dividends on an absolute basis every year. More specifically, the company actually raised dividends every year in 13 of the past 15 years, and FY2009 (2008-2009 Global Financial Crisis) and FY2019 were the only two years in which Hysan Development maintained the absolute amount of dividend payments rather than increasing them.

Hysan Development did not give a guidance for FY2020 dividends, but highlighted that the "progressively inclining dividend payout that it is something that we are very proud of" at the company's FY2019 results briefing on February 20, 2020. I believe that it is reasonable to assume that Hysan Development should at least maintain a dividend per share of HK$1.44 per share for FY2020. Hysan Development offers consensus forward FY2020 and FY2021 dividend yields of 5.1% and 5.2% respectively.

Valuation

Hysan Development currently trades at 0.38 times P/B based on its net asset value per share of HK$74.4 as of December 31, 2019, and its share price of HK$28.20 as of March 2, 2020. In comparison, the stock's historical five-year and 10-year P/B multiples were approximately 0.55 times and 0.63 times respectively. It is also worth noting that Hysan Development traded as low as 0.32 times P/B during the 2008-2009 Global Financial Crisis, which implies another 15% downside, even the stock trades down to this historical trough P/B level.

However, note that there has been no change in the capitalization rates used to value Hysan Development's properties in 2019 vis-a-vis 2018, despite the social unrest in Hong Kong last year. If the Hong Kong economy remains weak in 2020, occupancy rates and rents fall significantly, there is a risk that Hysan Development's net asset value per share could decline next year assuming higher capitalization rates are used.

Capitalization Rates Used To Value Hysan Development's Properties

Source: Hysan Development's FY2019 Results Presentation Slides

Risk Factors

The key risk factors for Hysan Development are a longer-than-expected time taken to contain the current coronavirus outbreak, the escalation of social unrest in Hong Kong again, and lower-than-expected dividends going forward.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.