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Morningstar | Swire Pacific's Focus on Organic Growth to Lift Profitability

Swire Pacific posted a good second-half result in line with our expectation. Overall, it was a solid year for the group, with Cathay Pacific and Haeco returning to profitability, adding to strong performance in properties and beverages. We increase our fair value estimate to HKD 102 per share from HKD 87 by factoring in the time value of money and the divestments at Swire Properties. Our thesis for the conglomerate is unchanged, and we expect improving returns in the medium term. While return on equity at a group level recovered in 2017 and 2018, profitability in previous years was subpar. Management is focusing on increasing the five-year return on equity from its current 7.1% while maintaining sustainable dividend growth on an absolute level. The divestment of City Plaza 3 and 4 will not be paid out as a special dividend, with proceeds applied to sustaining the ordinary dividend, along with further investments in the business. This is supported by a strong balance sheet with net gearing at a prudent 20% and cash balance of HKD 9 billion.

Privatisation of Haeco and the sale of the cold storage and paints businesses and the Kowloon Bay office tower are more fine-tuning to the group’s operations; we see little scope for large restructuring for the group. Organic growth remains, with beverages continuing to benefit from a realignment of geographies in China and new geographies in the United States. Rising consumption in travel is also expected to underpin increased travel demand for Cathay Pacific and rental growth for the group's investment properties, mainly retail malls, in China. For Swire Properties, management will prudently participate in land auctions in both Hong Kong and China, though land prices in Hong Kong remain demanding. The focus is on existing projects in Two Taikoo Place and the recently acquired 50% stake in Taikoo Li Qiantan.

There was no change in the challenging outlook for marine services, with fleet utilisation rates and average charter rates largely steady against the first half. Excluding the large write-down in the first half, losses for the division were steady at HKD 1.1 billion for the full year. Global average rig count for 2018 was around 10% higher than the previous year, based on data from Baker Hughes. While the number of exploration projects appears to have increased over the last year, this has not translated into higher charter rates. This is consistent with the commentary offered by the Singapore banks earlier this year with one bank also taking further allowance on nonperforming loans on lower collateral valuation for the fleet backing those loans. For Swire, total write-down now represents 35% of the fleet’s original value. Swire’s management said a turnaround will take some time and is not expected until 2021. The strategy to keep costs lower to ride out the cycle remains, and a divestment of the division does not make sense at the bottom of the cycle, in our view. As previously noted, we do not expect further cost savings as excess costs have been taken out of the division over the last few years. Capital expenditure for the division is less than 5% of the group. Management noted underinvestment in oil exploration could result in a supply shortage, with increasing activities thereafter likely to lead to higher utilisation and charter rates. The cyclicality of the industry means profitability could recover sharply if this is the case. Our forecast assumes slight improvement in utilisation rates and charter rates over the five years, with the division remaining loss-making.