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Morningstar | CK Hutchison Posts Solid 2018 Results with Retail Ops Resilient, Rumblings of a Positive Catalyst

CK Hutchison Holdings, or CKHH, posted a decent 2018 net profit of HKD 39 billion that beat our estimate by 9%. We think a largely resilient performance particularly from its retail segment and a telco outlook that has likely bottomed for the group, should prod some positive catalysts for this stock that has been out of favour. We lift our retail segment and ports margin assumptions leading to a rise in our five-year EPS CAGR estimate to 7.1% from 6.3%. There are concerns over the forthcoming regulatory resets for its U.K. and Australian regulated utility businesses could lead to lower tariffs but we think this should be mitigated by mid-single-digit growth in assets values. While this may lead us to reconsider our stable moat trend for CK Infrastructure Holdings, we do not think there will be any impact on CKHH’s no-moat and stable trend ratings. We think there is room for upside to our sum-of-parts fair value estimate of HKD 106 but CKHH is attractively priced already.

We were concerned softer consumer sentiment could slow retail sales in the second half of 2018 but sales were resilient particularly in Asia and Europe, and probably a sign that efforts to improve foot traffic are coming into fruition. Coupled with decent cost controls across all segments, CKHH’s EBITDA margin was stable. Operating income was impeded by one-off charges and a 15% jump in depreciation which was offset by a lower effective tax rate and minority interest payments.

News that Temasek is planning to sell 10% in A.S. Watson, CKHH’s retail arm, for USD 3 billion is a reminder that the spin-off value of CKHH’s assets are higher than what the group collectively trades at. If the speculated pricing is correct, CKHH’s retail business would fetch a value that is 67% above what we have factored in, lifting our fair value estimate for CKHH to HKD 119 if fully reflected. However, CKHH is not planning to spin off Watson anytime soon and as such, unlikely to benefit from the market premium.

Watson’s China operating margin is still easing, down to 19.1% in 2018 from 19.5% in 2017 and 21.8% in 2015. However, this is being offset by slight improvements in other regions. This is likely to remain one of the concerns for the group as rising online sales and increased competition from others had been eating into revenue. However, the revamp in its stores appears to be helping with revenue growth recovering for a second straight year and rising to 9.5% in 2018 from 4.2% in 2017. With 35% of Watson’s sales derived from unique products and improving online apps, we expect to see the recovery continue and factor in five-year revenue CAGR of over 5% for the health and beauty segment with stable EBITDA margin of 9.6%. The speculated USD 3 billion asking price by Temasek would price Watson's at around 17 times forward price/EBIT. This is not unreasonable and certainly reflects the value potential of Watsons should CKHH decide to spin it off.

Three Group performance was within expectations with the group’s active customer base and ARPU declining 4% and 8%, respectively, as competition remains steep in much of Europe. Although EBITDA margin was slightly better than expected, this was largely due to lower CACS as the group opted not to spend on customer acquisition. We think this spending should normalize. The purchase of the balance 50% stake in Wind Tre that completed in October was a key driver to the group’s telco growth and will remain so in 2019 with the full-year contribution. While Wind Tre continued to suffer from intense competition in Italy, the cessation of further price cuts by Iliad should lead to abating customer loss and ARPU stability. 3 U.K. performed well, we think helped by robust data usage and network upgrades. Also positive is that free cash flow will rise as the bulk of its spending for 5G spectrum has been completed and network spending is not expected to lead to raise group capital expenditure much given limited ports segment reinvestment.

We expect the full-year contribution of Wind Tre to raise the telco contribution to group operating income to over 36%, making it the largest business group in CKHH. This will also drive much of 2019 consolidated profit growth. We expect ports and Husky Energy contributions to lag – the former due to slowing global growth amid U.S.-China trade concerns and the latter due to lower selling prices. Particularly, we expect Husky’s income to decline 30% in 2019 on weaker prices, especially for synthetic crude. This should recover from 2020. However, the resumption of dividend payments from Husky is a positive to CKHH.

As mentioned in our update on CK Infrastructure Holdings, we expect mid-single-digit growth in the next two years ahead of the upcoming regulatory resets. The resets of Northumbrian Water, Wellington Electricity and South Australia Power Networks in 2020-2021 is likely to be a dampener for earnings that year followed by the resets of six other entities in 2021-2022. However, we think that the values of the assets themselves will growth at a mid-single digit pace to mitigate tariff drops. We have already lowered the market premiums in our valuation of the regulated assets in our valuation of CKI although we note that there may be downside risk to the earnings estimates in 2021 and 2022.