Swire Pacific's costly faux pas

Though not a major player in the residential market, Swire Pacific [19], through its subsidiary Swire Properties, got its fingers burnt pretty badly at its Tseung Kwan O residential project, which is a 49:49 joint venture development with Sun Hung Kai Properties [16]. The original site owners hold the remaining 2%.

The project has a total residential floor area of approximately 4.1 million sq ft, of which 2 million sq ft is attributable to Swire Pacific. This is the Group’s largest residential development project slated for sale in terms of attributable floor area.

Shrewd as the Group has always been in making business decisions, it was a case of unfortunate timing when it purchased the site for the project at the peak of the property market, just before the tide of fortunes turned against developers in late 1997.

According to a property market insider, the accommodation value (ie the unit land cost per square foot of buildable floor area) for the site came to approximately HK$3,500 ($448.96) per sq ft while the total development cost per sq ft could easily top HK$5,500 per sq ft. Current secondary market prices for residential flats in Tseung Kwan O are only HK$3,000 per sq ft.

The project, which is named Ocean Shores, is split into three phases. The first phase, comprising one-third of the total floor area, was almost sold out at an average sales price of HK$3,500 per square foot. Swire Pacific made a hefty provision of HK$2.072 billion in its 1998 accounts to reflect the loss made for this phase.

It seems more provisions are likely in the 2H as the second and third phases will soon be launched. Secondary market prices in Tseung Kwan O remain at approximately HK$3,000 per sq ft.

According to Midland Realty Agency - a subsidiary of listed Midland Realty [1200] - the number of transactions in major housing estates in the New Territories last week dropped 43% over the previous week to 53, mainly due to a cooling of buyer sentiment on the back of the precipitous fall of the local stock market and higher oil prices.

The Group would be lucky if it were able to sell all the remaining flats in Phases 2 and 3 (approximately 3,800 units) at a price range between HK$3,000 per square foot and HK$3,500 per square foot in the current sluggish market, particularly in the Tseung Kwan O district where there is huge potential supply coming from MTRC [66] railway extension line developments.

Assuming an average sales price of HK$3,300 per sq ft for the whole project (2 million sq ft attributable) against a unit development cost of HK$5,500, a shortfall of HK$2,200 per sq ft would mean a total loss of HK$4.4 billion. After deducting the 1998 provision of HK$2.072 billion, there seems to be a further HK$2.3 billion of provisions to be made either in the 2H of this year or in the next fiscal year.

Swire’s joint venture partner Sun Hung Kai took a decisive step in making a one-off provision for its interest in this project in its accounts for the year ended 30 June 1998.

Swire reported an interim net profit of HK$2.59 billion for the six months to June 30 2000, up 42.5% YoY. A strong performance on the aviation front, which contributed 42.8% of net earnings (compared with 2.6% in FY1999), was the chief reason for the impressive growth. Property, on the other hand, despite being a mediocre performer in the 1H, accounted for 55.8% (compared with 90.2% in FY1999) of total profit.

For the 2H, Group Chairman JWJ Hughes-Hallett is of the opinion that the Group’s investment portfolio should benefit from the growing shortage of high-quality office space which will see office rental and occupancy levels rise, as well as from the completion of refurbishments at two of its retail shopping centers - Cityplaza and Pacific Place. On the other hand, he has reservations about the outlook for residential sales.

Strength shown in the aviation division in the 1H is expected to carry through into the 2H.

Luckily for the Group, gyrations in the residential sales market have not had much of a detrimental effect on its overall performance as it otherwise would, were its property holdings not comprised mainly of investment properties such as Grade A offices and high-quality shopping centres. These act as income cushions in turbulent times.

With a fairly comfortable gearing ratio of 23%, the Group can afford to be flexible in pursuing suitable investment opportunities as they arise, thus ensuring future profit growth. This was confirmed by Standard & Poor's recently removing the Group from “CreditWatch” and reaffirming its “A-minus” rating.

Most analysts expect any provisions that have to be made for the Tseung Kwan O project to be offset by continuing strong aviation earnings and much improved office and retail rental income in the 2H.

Morgan Stanley Dean Witter has put a fair value of HK$54 on the stock and estimates NAV per share at HK$69.37. The latest consensus EPS estimate for FY2000 is HK$3.54. The stock is trading at a forward PE of 14 times and a discount to NAV of 2x8%. Morgan recommends accumulating the stock below HK$50.

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