Henderson's Lesson for Kerry
16 June 2003

Time to take another look at the ongoing offer by Kerry Holdings Ltd, controlled by Robert Kuok Hock-nien (Mr Kuok), to privatise Kerry Properties Ltd (KP, 0683).

What a difference 6 months makes. On 2-Jan-03, minority shareholders of Henderson Investment Ltd (HI, 0097) blocked a HK$7.60 per share privatisation bid by Henderson Land Development Co Ltd (HLD, 0012) by a slim margin.

Clifford Lam, an analyst at Merrill Lynch, was quoted in the South China Morning Post the next day as saying in relation to the share price: "It will fall to below HK$6 per share and never rebound [to the same level as HLD's offer]".

Well, he was wrong on both counts. HI reached a low of $6.20 after the offer was vetoed, and closed today at $7.60 per share - and it has paid a dividend of $0.11 since the offer was vetoed, for a total return of $7.71. Meanwhile, since 2-Jan-03, the Hang Seng Properties Sub-Index has fallen 3.0%, so HI has actually out-performed the index in that time. As the market price is now back at the offer price, anyone who disagreed with our opposition and thought it was a fair offer, but didn't sell in the market before it was vetoed, can now get that same price in the market, and keep the dividend. But if HLD were to try again to privatise HI today, it would obviously have to offer a higher price. Minority shareholders have been vindicated in their decision to reject the offer.

Now back to KP, which on 14-May-03 announced a massive 37-day delay to the posting of the offer document, which normally has to be posted within 21 days of announcement. The stated reason was "due to additional time required to accommodate the court process to convene the court meeting", but don't blame it on Bermuda, because the real reason was that KP needed more time to prepare the offer document and in particular the valuation reports, including properties in HK and the mainland.

In this morning's papers, but dated Friday 13-Jun-03, KP announced that it had obtained new valuations of its property and infrastructure projects as at 30-Apr-03. These showed:

• a devaluation in investment properties, hotel properties and other freehold and leasehold land and buildings, resulting in a charge against the income statement for the 4 months to 30-Apr-03 of $914m
• a provision for unsold properties at Constellation Cove (a residential development project) of $55m
• a provision for decline in the carrying value of associated companies of $137m

These non-cash items total $1,106m, or about $0.93 per share (at 30-May-03 there were about 1,184,5m shares in issue). In addition, due to the introduction of a revised accounting standard SSAP 12 in Hong Kong, KP will accrue for deferred taxation even though it is "not expected to crystallise in the foreseeable future", and is making an additional provision of about HK$1.2bn retrospectively for the liability as of 31-Dec-02, reducing the net asset value accordingly by about $1.01 per share.

We accept that KP must abide by accounting standards, but don't be fooled into thinking that this amount represents an unavoidable liability. The figure of $1.2bn, at 2002 tax rates of 16% in HK, would imply a total contingent taxable profit of $7.5bn, or about one-third of net asset value of $21.0bn at 31-Dec-02.

The way in which deferred tax liabilities are computed under SSAP12 is extremely complicated, but it basically boils down to providing for the tax on the difference between the carrying amount and "tax base" of an asset, on the assumption that the entire carrying amount will be realised in the form of future revenues over the lifetime of the asset and that the corresponding profit will be taxable. But life is not that simple, because firms have a habit of financing these assets with borrowings, paying interest on those borrowings, which reduces the taxable profit. So the liability is almost certainly overstated.

Furthermore, insofar as these deferred tax liabilities relate to fixed assets such as investment properties and hotels, if KP were ever to sell them, then the remaining deferred tax liability would probably simply vanish. KP would likely sell the subsidiary which owns the property, but even if it directly sold the property, in Hong Kong, disposals of fixed assets, or what the taxman calls "capital assets" are not assessable to profits tax. So the accounting standards require KP to record an asset at valuation together with a corresponding deferred tax liability that may disappear if that valuation is ever realised in a sale.

The Henny Penny approach

It is standard practice in privatisation proposals for listed companies to look for every possible way of reducing their apparent value and talking down their prospects. The controlling shareholder is of course the munificent benefactor who is seeking to buy all the shares not because he thinks the company has any prospects, but he just wants to help the little minority shareholder avoid a loss.

We call it the Henny Penny approach to investor relations, from the children's fairy tale. In the case of KP, we estimate the total deduction of the asset devaluation and the deferred tax provision to amount to $1.94 per share.

The original NAV of $17.94 per share at year end has also been diluted to about $17.73 per share due to the issue of shares for the scrip dividend. However, we'll make an educated guess that the company has also booked $250m of profit for the 4-month period, or about $0.21 per share, which cancels out the dilution.

Overall then, KP is likely to claim a 30-Apr-03 net asset value of around $16.00 per share when its privatisation document finally sees the light of day, after deducting that $1.01 of newly introduced deferred tax liabilities. KP announced today that it will delay posting for another 10 days until on or before 30-Jun-03 "in order to give all the parties involved time to assess the impact" of today's announcement.

There's a subtext there. If they were simply going to stay at the current offer level, then they would have posted the document and started the ball rolling. However, by delaying, they give time to negotiate with investors who are seeking a higher offer, and to come to a deal which is acceptable to all.

Ironically, by taking so long to get its offer document ready, KP has missed the deepest doldrums of the market. The war on Iraq is practically over, SARS is practically gone, and markets have climbed strongly around the World, which is a more confident place than when the first offer of $8.50 was made on 23-Apr-03. Take a look at this table:

As you can see, although Kerry Holdings has increased its offer for KP by 11.2% since it first announced the privatisation plan, by comparison with other property stocks in the HS Property Sub-Index and with the HSI, it has not kept pace.

Our view

At this offer level, the chance of success is close to zero. Even if you accept the estimated revised NAV figure of $16.00 per share after deducting deferred tax liabilities which were "not expected to crystallise in the foreseeable future", if ever, then the offer at $9.50 still represents a discount of 40.1%. If you look at it on the old basis, before the deduction of deferred tax, then you are talking about NAV of $17.01 and a discount of 44.2%.

Whether this bid follows the same fate as the bid for Henderson Investment is now entirely up to Kerry Holdings. Mr Kuok will either have to make a substantial increase in the offer or expect to be voted down. Webb-site.com editor David Webb is a shareholder of KP.

© Webb-site.com, 2003

Organisations in this story

• KERRY PROPERTIES LIMITED

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