Saturday, June 27, 2015

Why I Bought Soundwill Holdings

The situation in Sears Holdings is sad. I have watched the confidence of Eddie Lampert and Bruce Berkowitz for 8 years. Meanwhile the situation at Sears is getting worse and worse. The company is starting to monetize its real estate holdings. But it seems to be swimming against the flood of losses quarter after quarter. In the most recent quarter, the company had about negative $500M of cashflow! Now by selling assets or rights to assets to a newly created entity Seritage, SHLD gets some badly needed cash. But to do what? Pay off the negative cash flow for a few more quarters?

I just cannot now see how this will end well for SHLD holders. Maybe it will end well for Seritage shareholders, but not for SHLD. The bullish narrative on SHLD is that the company's real estate is worth much more than the carrying value on the balance sheet. And this mispricing is not reflected in the stock price. I even wrote a piece on it. The underlying reason is that US companies use GAAP, whereas the rest of the world uses IFRS standards. GAAP accounting for the most part treats real estate property at cost, minus impairments. However, IFRS allows real estate to be revalued yearly. Any fair value gains becomes non-cash income. But I'll stop mentioning SHLD now because this post isn't actually about SHLD. I am writing about my latest purchase, Soundwill Holdings (HK:0878).

Price HK$ 15.080
Market Cap HK$ 4245.02 M
(USD $ 547 M)
P/E TTM 2.6 x
Div yield 2.0 %
P/BV 0.25
ROE9.8 %
LT debt/Equity0.1 %
Soundwill Holdings (HK:878) is a real estate company that has been around for more than 20 years. Today, this company's earnings are fantastic because of the hot Hong Kong real estate market and the use of IFRS accounting rules. As the side box shows, the numbers are fantastic. And it is primarily due to their real estate fair value gains.

Soundwill holdings develops and owns properties in Hong Kong. The company rents out retail properties in very expensive areas. Some prime real estate can fetch USD $5000 per sq ft per year! The company's flag ship location is Soundwill plaza. Occupancy is at or near 100% and rents have skyrocketed in recent years. This explains the real estate value gains. IFRS allows real estate values to be adjusted to the current fair value on the balance sheet. Current fair value is generally based on projected cash flows from rents and the prevailing discount rate.

The company also has another segment which develops property for sale in China, usually in partnership with other companies. This business is scary because many believe China is in the midst of a housing bubble. I don't really have an opinion and my opinion doesn't really matter anyway. Such macro issues are not what I dwell on. I think China is really a market too difficult for someone like me to understand. I don't want to participate in it, but it is the company's secondary business. The company has no more than 15% of their assets in China.

The company is 69% owned by Foo Kam Chu. Her daughter, Chan Wai Ling, is a major executive in the company.

I have annual reports going back 15 years. Fifteen years ago the company was into real estate as well as telecommunications. The company acquired a stake in another company called Vision Telecommunications. Interestingly, the stake was purchased from Mrs. Foo and Mrs. Chan in exchange for about 15% of Soundwill stock, which was priced at HK$0.63 a share. Other unscrupulous CEO's have similarly sold entities that they own to their companies at inflated prices. The inflated amount is reflected on the books as goodwill. I am not saying that the Vision transaction is one such case. I don't have much information about the transaction as it happened more than 15 years ago. However, the Vision purchase goodwill of HK$151M was enough of a concern that the company auditor Moores Rowland qualified the 2001 Annual report by stating that they cannot verify the goodwill. And in the next year, after the fiscal year had ended and presumably Moores Rowland had begun the audit, they resigned. And Grant Thornton came in as a late replacement auditor. Then the goodwill controversy diminished somewhat when the company wrote down the entire Vision goodwill in the 2002 financial statements. When I looked at this history, it certainly raised my eyebrow. Then it gets more interesting. In 2006, the management tried to replace Grant Thornton with a smaller firm. The management said they were only making the change for cost reasons. But then a month later, they backtracked on their decision and rehired Grant Thornton because the company bankers raised concerns over the succession of recent auditor changes. Well, at least the bankers are doing their jobs.1

By 2003, Mrs. Foo owned 60% of Soundwill, and the company was suffering. The company lost close to HK$500M in each of the last 5 years! And in that year, the company did a 50:1 reverse split. Meanwhile, the company quietly dropped mention of telecommunications.

From 2004 onwards the company turned around. It quickly posted earnings with help from lots of capital injection mostly through loans. The loans were mostly made by Mrs. Foo and were convertable to stock. Of course with the stock fortunes improving, Mr. Foo quickly took advantage of the conversions to increase her stake in the company to 69%. I have tabulated data from the financial statements of the last 15 years.2

op profit gain from sales of subsidiaries fair value gain earnings equity cash flow
2001 (91,516) 0
(237,830) 460,800 234800
2002 (323,382) 4,712
(411,771) 293,500 (48,200)
2003 116,800 1,100
61,800 921,500 14,900
2004 76,100 (200)
28,300 1,805,500 36,800
2005 707,300 8,400 564,900 548,600 2,177,900 90,700
2006 570,000 101,900 361,600 423,100 2,602,500 (52,800)
2007 288,700 62,500 1,093 1,063,000 3,677,400 (521,500)
2008 266,900 33,600 (135) 159,400 3,873,000 (337,000)
2009 370,600 18,300 964,400 1,053,400 4,943,800 421,300
2010 467,233 16,400 1,769,600 1,738,900 6,716,800 457,700
2011 321,100 461 2,032,900 2,119,000 10,277,700 588,000
2012 915,000 3,311 2,692,300 3,321,300 13,802,200 878,900
2013 447,300 0 1,276,500 1,338,200 15,037,000 1,356,300
2014 1,376,500 114,300 638,800 1,644,600 16,662,000 1,801,000

The IFRS accounting rules did not take affect for all of the last 15 years, which is why there were no fair value adjustments in earlier years. As the table shows, most of the earnings are from fair value adjustments. However, in the last several years cash flow has been increasing significantly, which is very encouraging. Soundwill is obviously riding high on the real estate bull market in China and, to a lesser extent, Hong Kong. This cannot go on forever. But on the other hand, Soundwill is extremly cheap compared to its seemingly inflated assets. The company is still trading for a quarter of book! And it has zero long-term debt. Even if its assets drop by half, the company would still sell for less than book.

Over the three year life of this blog I have searched hard for bargain smallcaps. But it is getting harder and harder given the elevated equity markets. This is why, for the first time, I have exposure to mainland chinese real estate. Many wise investors advise to be disciplined and resist lowering one's standards when markets are elevated. Time will tell whether my choice to invest in Soundwill is a mistake because I couldn't find anything better.

1. Today the company auditor is BDO because BDO merged their HK operations with Grant Thornton.
2. I copied this information from their yearly financials and the numbers very likely have some errors. Please read the disclaimer on the right.