Abstract: The 34% year-on-year decline in Hong Kong's recurring net profit in 2016 was mainly due to weaker operating performance compared to China Travel (0308.HK; unrated) and the devaluation of the RMB. However, we believe that the 2017 market consensus forecast (recurring net profit growth of about 26%) is still expected to be realized, because (1) the company's core business shows signs of stabilization; (2) the company appointed a new management team at the beginning of this year; (3) the RMB exchange rate has been relatively stable since this year. The company's current net market ratio is 0.82 times. The valuation is quite cheap from this point of view, but in terms of price-earnings ratio, the valuation is still relatively high (price-earnings ratio in 2017 was 23 times). As investors become more cautious about cyclical industries, we believe investors will refocus on the company if the company's new management makes good use of its HK$4 billion net cash (about one-third of the market capitalization) to find suitable M&A targets to improve profitability.
2016 performance review. According to report data, China Travel Hong Kong's net profit in 2016 fell 74% year-on-year to HK$335 million, mainly due to sales revenue recorded in 2015 due to the sale of the power generation business and no related revenue in 2016. Excluding the relevant one-off items, net profit fell 34% year-on-year to HK$413 million, mainly because (i) the company made additional expenses on Window of the World and Splendid China to enhance products and services, but the potential benefits were not immediately reflected; (ii) the weakening of the leisure and vacation business; (iii) the decline in travel document business; and (iv) the devaluation of the RMB by 5% to 6% in 2016, and since the company's financial statements were presented in Hong Kong dollars, the performance was affected as a result.
Improve leisure resort business. As the leisure resort business lost around HK$70 million last year, the company is looking for opportunities to sell some underperforming assets, such as Haiquan Bay in Xianyang. The project has a book value of around HK$300 million. As for Haiquan Bay in Zhuhai, the first phase of 2016 had contract sales of approximately HK$1 billion (120,000 square meters). The net profit margin of the project is over 20%, so if the project is delivered before the end of this year, China Travel Hong Kong will be able to account for about HK$100 million in net profit (49% of equity).
Meanwhile, the first phase still has 120,000 square meters of saleable area this year.
The hotel and theme park business is recovering. Management indicated that the hotel business experienced a moderate recovery in the first few months of this year. According to government statistics, overnight visitors to Hong Kong increased 6.4% year-on-year in the first quarter of this year. Also, the number of visitors to Splendid China Theme Park, which was upgraded last year, increased 14% year over year during the Lunar New Year holiday period.
Mergers and acquisitions will be the main driving force for the growth of the tourist destination business. According to management, potential acquisitions of natural and cultural attractions will mainly come from third parties. Generally, the company directly negotiates with the provincial government. The projects involved are comprehensive projects, not just a scenic spot.
The company aims to obtain 2-3 projects per year; the target internal rate of return is 12% or more. The company has two main ways to improve revenue: (i) improve efficiency and marketing, which is implemented more quickly; and (ii) improve the overall planning of the project, which may take 1 to 2 years to produce benefits. The company's current net cash position is around HK$4 billion, and the pace of mergers and acquisitions will affect the rate at which profitability will increase.
Output management experience is also an opportunity to become a new source of revenue. Since the company has extensive experience in managing scenic spots, the company is trying to export its professional management knowledge to third parties by charging management fees, sharing profits, or investing in minority shares, but there are no completed cases yet.
The second phase of Haiquan Bay in Zhuhai was the engine for medium-term growth. The scale of the project is about 700,000 square meters (the land area ratio has not yet been determined), which is significantly larger than the 240,000 square meters of the first phase. Investment partners are yet to be determined (Phase 1: China Evergrande). Assuming a net profit margin of more than 20% and an average selling price of more than HK$10,000 per square meter, the potential revenue contribution will not be small, depending on the company's shareholding ratio. Currently, China Travel Service in Hong Kong is expected to begin pre-sale of the second phase of Zhuhai Haiquan Bay in early 2019.
Other potential restructurings. As the parent company is undergoing a restructuring, China Travel Hong Kong does not rule out that its hotel business and travel agency business may play a role in the parent company's restructuring, but there are currently no details.