The Hong Kong And China Gas Company: Value Creating But Not Value Maximizing For Shareholders
- HOKCY's large valuation premium over peers is due to its monopolistic position and its unregulated tariff setting ability in its core Hong Kong market.
- However, since 2008, management made a major strategic change in corporate direction and decided to expand into China in pursuit of growth.
- On one hand, this represented a diversion of cash flows that could have been distributed to shareholders in the form of large dividends.
- On the other hand, HOKCY's PRC operations' low ROA and ROIC belie its value creation. HOKCY enjoys low cost of capital. Companies should invest as long as ROIC exceeds WACC.
- Value creation is not value maximization. Investors could likely have redeployed dividends from HOKCY to earn returns above mid-single digits (which is the return of HOKCY's PRC business).
Hong Kong and China Gas ("HKCG") (OTCPK:HOKCY) rose to become the monopoly gas supplier in Hong Kong as a result of government regulatory decisions in the 80s and 90s. The policies at the time discouraged the use of bottled LPG in households and banned transmission of LPG under public roads on one hand, and encouraged the upgrading of substandard water heaters and the use of piped gas on the other hand, which effectively led to the creation of Hong Kong and China Gas as a monopoly (Source: "Safety Regulation and the Rise of Towngas in Hong Kong" by Centre for Asian Business Cases, The University of Hong Kong). Meanwhile, since HKCG does not officially have a franchise or exclusive rights to supply gas in the territory, it operated in an “open market environment” in that sense. Specifically, the government did not regulate Towngas in price or profit and does not do so even today. Under an agreement in 1997, the company only needs to give notice three months in advance about any tariff adjustment and justifications, and brief Legco and the Environment Bureau’s Energy Advisory Committee.
Being a monopolistic utility business whose tariff is not regulated and not linked to capex is so valuable in terms of competitive advantage, it explains why HKCG trades at such a huge premium to other utility peers. Since 2008, however, management decided to expand into China in pursuit of growth. This was a major strategic change in corporate direction. And as with all major strategic endeavors and/or expansions into new markets, there is always a risk of de-rating or re-rating*. In HKCG’s case, the stock has re-rated handsomely from 10-20x forward P/E before 2008 to 20-30x post 2008.
*Initiatives that don’t get far enough to contribute meaningfully to revenue/profits get ignored by the market in valuation.
The argument for de-rating
Some may argue that the increasing share of China revenues in the company’s business should merit a de-rating. This is because instead of remaining a quality dividend play with which investors wouldn’t mind low growth as long as cash flows were stable and payouts were high, HKCG chose to become a “diversified conglomerate” that sits awkwardly in nowhere land between the dividend and growth spectrums.
Misallocation of capital may be too strong a description, but arguably management’s growth incentives have diluted the quality of the business in exchange for larger scale. If management stuck faithfully to its stronghold (i.e. Hong Kong only), with its low capex, HKCG could pay out a lot more in dividends to shareholders instead of diverting those cash flows to the China business.
HKCG does not report historical capex split across geographical regions, but it does disclose a 3-year rolling figure of planned capex and investments for the future. While it would be good to have the former for track record illustration, the latter is arguably more value relevant. I lay out charts comparing the 3-year rolling forecasted EBITDA with the 3-year rolling forecasted capex/investment spend for each of HKCG’s Hong Kong and China business below.
(Source: company information)
Some investors may argue that the cash flow graph for PRC doesn’t look that bad. But all those negative red bars, as much as -HKD 10 million in some years, could hypothetically have been distributed in the form of dividends instead of thrown at business initiatives that generate meager returns.
The argument for re-rating
Besides asset inflation tailwind from low interest rates globally, HKCG has successfully developed a new source of growth that is value creating to shareholders despite the optically low returns.
The key is that HKCG enjoys a very low weighted average cost of capital (WACC) of 4.1%, which means in pursuit of growth it can take on projects that are relatively low return and still create value.
The main reason for the low WACC is HKCG’s low beta of 0.5 due to the near-indestructible moat of its core Hong Kong business and the defensive nature of utilities generally. This coupled with low interest rates globally give a stunning low cost of equity of 4.8%, which together with the low cost of debt (3.2% pre-tax) results in a WACC of 4.1%.
Academic literature (i.e. Valuation: Measuring and Managing the Value of Companies, by Tim Koller, Marc Goedhart, and David Wessels) says that companies should still invest if ROIC exceeds WACC, even if new projects have ROIC lower than existing levels and investing will therefore reduce the prevailing company-wide return. HKCG’s PRC operations generated historical ROA of 5.7% based on FY16 to FY18 average. This is consistent and within the return cap of 7% ROA on gas distribution imposed by China’s NDRC. Since invested capital is total assets minus non-interest-bearing current liabilities, we can expect ROIC to be above 5.7%, implying a greater spread over WACC than what the ROA suggests.
Whether it is worth diluting the quality of the business in exchange for growth and scale is simply another form of the ROIC versus growth trade-off, and I have shown above that HKCG’s PRC operations are still value creative given their low WACC threshold.
The reason why investors think the PRC operations are a “low quality business” also has a lot to do with the policy driven and highly regulated nature of the China energy market. However, such risks are arguably already reflected in the 7% return cap and low (but-still-above-WACC) ROA of 5.7%, and I have used these same figures to settle the value creation or destruction question.
Conclusion: expansion was not the best choice although the market seems to think so
The fact that HKCG’s expansion into China was value creating does not mean that shareholders are better off with this option than if they had received the investment proceeds as dividends. Although HKCG PRC business manages to generate returns in excess of cost of capital, it is highly likely that investors could themselves have redeployed the cash distributed as dividends to earn returns superior to the mid-single-digit returns* of HKCG’s PRC business. The academic theory says ROIC>WACC creates value, but that is different from maximizing value. The market, obsessed with growth, has graciously but also unsurprisingly looked past this fact.
*Mid-single-digit returns refer to ROIC somewhere above 5.7% but the exact number cannot be determined due to limitations on company disclosure.
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