Xinyuan’s recently filed 20-F shows the company’s actual gross margin achieved each year by province and the estimated gross margin that will be earned on all projects currently under development. Key conclusions:
- The company has a long-term record of success in its core markets of Zhengzhou and Suzhou/Kunshan
- Weak current profitability is largely due to poor timing of land acquisitions in 2013-2014 rather than a fundamental flaw with the projects or the company’s business model
- Only 2 (Chengdu and Sanya) out of 21 current projects appear problematic
- Gross Margins are reasonable relative to comps
Acceptable Gross Margins
Important Factors Affecting Gross Margins
- Brand Image. Chinese developers hope that pre-sales will fund a substantial portion of the cost of construction. A well-established reputation in a market provides buyers with confidence in a developer’s ability to deliver a quality home and enables earlier sales at higher prices. A larger volume of pre-sales reduces the need for borrowings whose interest expense is capitalized and then recognized as part of Cost of Real Estate Sales.
- Market Timing. Developers can enhance their margins by acquiring land when the real estate market is weak (e.g. 2012 and 2015) and then by selling homes when the market is strong (e.g 2H13 and 1H14).
- Land Acquisition Strategy. Developers in China acquire most of their land by offering the highest price in public auctions. Non-auction acquisitions can provide an opportunity to acquire land at more favorable pricing leading to higher margins.
Xinyuan’s Gross Margin Achieved by Province
- Henan Province is Xinyuan’s home base. The company’s brand is well-known and the company’s projects have produced consistently high returns. Xinyuan’s 2015 margins were much higher than competitor Central China Real Estate (HK:0832) which does 100% of its business in Henan and earned only 22.2% last year. Pages 55-56 of Xinyuan’s 20F describe how cooperation with the Zhengzhou government in urban planning has provided access to land acquisitions on favorable terms.
- Jinan has been a major focus for Xinyuan investment in recent years, but returns have been merely adequate. The market’s recent price trend has been weaker than national averages due to an oversupply of inventory.
- Jiangsu was a good market for Xinyuan for many years, but recent margins have been depressed by the Suzhou Lake Royal Palace project. Last week Xinyuan acquired a new land parcel in Kunshan (LINK). The positive aspects of this investment are:
- Maintains Xinyuan’s presence in a market where it has a record of success
- Close to the existing Kunshan Royal Palace and Kunshan International City Garden developments.
- Very close to the border of Shanghai City and within easy walking distance of the Shanghai #11 subway line
- Suitable for Shanghai commuters while outside of the recently implemented Shanghai housing market restrictions
- Modest size (480mm RMB)
The negative aspect of the Kunshan purchase is simply timing. The local market is very strong and many companies are competing to acquire more land in the area.
Xinyuan’s margins were a bit weaker than Future Land and CIFI, competitors with high Jiangsu exposure which reported 2015 gross margins of 20.4% and 24.1% respectively.
Projected Gross Margins by Project
Xinyuan’s Percentage of Completion accounting treatment requires that the company estimate the lifetime revenues and development costs of every project
Most of the lower return projects are on land that the company acquired at high prices near the market peak in 2013/2014.
- Land for Jinan Royal Palace was acquired in December 2013 for RMB 1.2Bn
- Land for Suzhou Lake Royal Palace was acquired for RMB 1Bn in September 2013
Prices at this project have been rising in the strong Suzhou market and it’s likely that realized margins will end up higher than the 20F estimate
- Land for Chengdu Thriving Family was acquired in February 2014 for 933.8mm. The project is far from the city center in a new district that has not yet become popular. If the projected margin drops below zero then Xinyuan will have to take an impairment charge.
- Land for Shanghai Royal Palace was acquired in April 2014 for 914mm. The location is far from the city center and not currently close to the subway, but the #17 line will be extended to the area in 2017 with a stop less than one mile from Xinyuan. The Shanghai market has been very strong and the company is currently marketing some higher priced units. It’s possible that margins will end up higher than the 20F estimate. Participation in the Top Cities also brings intangible benefits through enhancement of the Xinyuan brand image.
- Land for Sanya Yazhou Bay was acquired in February 2014 for 357mm. The projected return is very high, but realized return is very likely to end up lower as capitalized interest will accumulate due to slow pre-sales. The appearance and location (adjacent to the beach and near the large Nanshan Mountain park) appear attractive. Xinyuan may need to lower prices or significantly change its marketing strategy. It’s possible that Xinyuan’s middle class brand image is not a good fit for a vacation property.
Xinyuan’s profitability can increase significantly over the next two years if it avoids reinvesting the proceeds from sales of the lower margin projects into new poorly timed land purchases.
Comparing Xinyuan Gross Margins with Comps
Despite the burden of low margins related to poorly timed land acquisitions, Xinyuan’s 2015 gross margin fell within a normal range for the industry as many competitors had their own problems during a weak market. Looking at some companies which produced better than average results:
- Yuzhou benefited from its leading presence in two good markets (Xiamen and Hefei). The company keeps a strong focus on acquiring land cheaply.
- Fantasia benefited from its rapidly growing property management business – its listed subsidiary Colour Life reported a gross margin of 54.9%.
- Modern Land found success with its brand emphasis on incorporating green technology into building design
Comparing Xinyuan to the leaders:
- Xinyuan has potential in growth of its own property management business which was recognized last year as #16 in China, well above Xinyuan’s #73 ranking in sales volume.
- Xinyuan has built a strong brand image around its Chinese/American identity.
- Xinyuan needs to demonstrate better focus on cost control.and prudent land acquisition.