Xinyuan Real Estate: Improving Profitability Not Reflected in Falling Share Price

A year of excellent progress in operating performance and delivery of value to shareholders has not been fairly reflected in Xinyuan’s share price which sits near a 52 week low. Improving profitability removes justification for a lower valuation than Hong Kong listed peers whose share prices have risen sharply.

• Xinyuan’s average gross margin on projects currently for sale is 30.2% at 12/31/16, up from 20.5% at 06/30/15
• Xinyuan’s average cost of RMB financing is 7.6% at 12/31/16, down from 10.0% at 6/30/15
• Xinyuan’s unrestricted cash on hand rose to $578mm at 12/31/16, up from $160mm at 6/30/15
• A broad range of new business initiatives can improve Xinyuan’s brand image and provide new paths to value generation
• Xinyuan shares are -14% YTD (to 4/13) while 7 HK-listed peers are up an average +31%

Source: Koneko, Google Finance chart link

Topics covered in this article:

• Margin Improvement
• Financing Cost
• New Business Initiatives
• Peer Comparison
• Investor Relations
• Buyout Potential
• Near-term outlook
• Risks

MARGIN IMPROVEMENT

Prior articles (04/11/16 and 09/21/16) described the deterioration in Xinyuan’s gross margins following its poorly timed overexpansion in 2014. Xinyuan paid too much for land near a cyclical peak and expanded into new markets where its brand was not well-established.

Xinyuan’s percentage of completion accounting treatment requires the company to estimate life-of-project sales and expenses and then report income statement revenue in line with contract sales. These project level estimates illustrate the adverse impact of the 2014 overexpansion, but also show that strong returns are expected from the portfolio under development at 12/31/16.

The dispersion of project returns shows good estimated profitability from nearly all current projects. Returns have been boosted in strong markets, older low return projects have been sold out, and newer high return projects have begun sales:

Xinyuan also has excellent prospects at projects which have not yet begun pre-sales:

Project Name	Sales Launch	Comment
Zhengzhou Fancy City 2 (North)	3Q17	Fancy 1 has a projected return of 29%, Fancy 2 has 31%. Further expansion of an established successful project should bring a higher return.
Zhengzhou International New City 2	3Q17	New City 1 has a projected return of 29%. Further expansion of an established successful project should bring a higher return.
Xingyang Splendid 3	TBD	Splendid 2 has a projected return of 35%. Further expansion of an established successful project should bring a higher return. Xingyang is the kind of “spillover” market currently enjoying strong sales. It’s just outside Zhengzhou with better affordability and no Housing Market Restrictions.
Beijing Liyuan	TBD	Low land cost in an excellent location should bring a high return. See 04/13/16 article
Changsha New Project	3Q17	Uncertain, but downtown location and a large commercial component may ensure a good return. Investors can monitor Xinyuan’s project page for updated information.

Future phases of existing successful projects (Xi’an Metropolitan has a total planned floor area of 1.35mm sqm and Zhengzhou International New City with a total planned floor area of 4.2mm sqm) provide comfort that the company has a pipeline of development potential that will continue to generate good and excellent returns beyond those estimated at 12/31/16.

Margin improvement will bring multiple benefits:

• Higher profitability from the same volume of sales
• Elimination of the gap in profitability relative to the average of HK-listed peers
• Resilience to cyclical and policy fluctuations

FINANCING COST

Real estate development is a capital intensive business. Access to capital on attractive terms plays an important role in determining project and company profitability. Xinyuan’s poorly timed overexpansion in 2014 followed by slowing sales led to a bloated balance sheet financed at high rates. Cost of sales was inflated by higher capitalized interest expense, profitability suffered, and the company was at risk of a liquidity crunch if sales weakened further.

• Bank loans to Chinese property developers carry modest rates, normally require pledge of property assets as security, and have restrictions on availability of funds.
• Domestic bond issues provide long-term unsecured and unrestricted financing at modest rates.
• Trust and other non-bank loans carry high rates, normally require pledge of assets as collateral, but usually do not have restrictions on availability.

A bloated portfolio and slowing sales forced Xinyuan to use large amount of trust loans at rates of 11-12% in 2014-2015. But over the past year the company diversified its sources of financing, reduced rates, and accumulated a large reserve of unrestricted cash. This cash could finance land acquisitions if attractive opportunities are available, pay down remaining higher cost debt as it matures, and provide a large cushion if there is a slowdown in property sales. Preliminary indications are that the company’s financial position was further strengthened in 1Q17 by strong sales and only modest land expenditure.

NEW BUSINESS INITIATIVES

The Chinese property market enjoyed a golden era through 2013 with strong gains in area sold, but then became more challenging for industry participants. Price appreciation has been concentrated in a few desirable urban areas (see 11/07/16) where shrinking land supply and rising cost favor well-managed companies in strong financial condition. Xinyuan stumbled with poorly timed land purchases, but has also undertaken a broad range of new business initiatives with potential to develop new sources of profitability:

Investment Property. The company held $160mm of commercial space within its developments for long-term investment at 12/31/16, a significant increase from $71mm at 12/31/15. Minimum rental income will be $8.5mm in 2017, but the shopping centers should also receive a participation in tenant sales. In accordance with US GAAP the investment property is carried at cost, but this year’s participation rent is likely to demonstrate that the fair value of these properties is significantly higher than their balance sheet book value.

Property Management. Last year Xinyuan filed an application (LINK) to list its property management business on China’s New Third Board, a domestic OTC market. Several competing businesses are listed in Hong Kong:

An independent listing should draw attention to the value of this steadily growing asset-light business.  Xinyuan currently manages less area than the industry leaders but ranked an impressive 14th nationally in a comprehensive CRIC assessment combining measures of scale, service quality, growth potential and social responsibility. Xinyuan’s listing application was approved on 3/15/17 (NEEQ:870929 quote), but the shares have not yet traded because 94% are still held by the parent company and 6% were sold to executives last year. Fair value for the property management business is likely between US$34-86mm, a significant premium to the 12/31/16 book value.

If the NEEQ listing becomes active then it could provide currency for accretive acquisitions of management contracts from other developers (as Colour Life has done).  It could also set a precedent for future domestic listings of other subsidiaries, perhaps even Xinyuan China 鑫苑中国 (the primary real estate development business).

Financial Services. Xinyuan has made preliminary efforts to participate in at least two financial services ventures that could be complementary to the existing real estate business. It committed 300mm RMB (about $43mm) to acquire 10% of the equity of a proposed reinsurance business (天圆再保险股份有限公司). I believe the license application is still pending and no funds have been invested yet. The company acquired 70% of an investment management company (Xinrock) with no current operations. In a recent interview a Xinyuan executive explained that the company was seeking to provide ways for people to conveniently invest in real estate through funds and securities rather than direct ownership of real property assets. The company has also partnered with IBM and Tsinghua University in developing a blockchain-based platform for real estate transactions (news link).

Each of these ventures is at a start-up level, but has great potential as the property market becomes more mature and professional.

Brand Image. Xinyuan has been emphasizing integration of new technologies into homes and communities. These innovations attract media attention and may cultivate a distinctive image for Xinyuan properties that may earn a premium price from home buyers. A Xinyuan security robot on patrol:

PEER COMPARISONS

Seven companies are selected here as benchmarks for Xinyuan based on these characteristics:

• Regional developers like Xinyuan that expanded to national Tier 1&2 cities (except Central China which has remained focused on Henan Province which is still Xinyuan’s most important market)
• Privately founded with no SOE connection
• Rapid growth and potentially appealing share values
• Hong Kong listed and using HK Financial Reporting Standards (except Xinyuan)

Xinyuan’s falling share price has left it significantly cheaper than peers.

Four areas will be examined in more detail:

• Margins
• Credit
• Payout ratio
• Investor Communications

Margin Comparison. Xinyuan has suffered from weaker than average profitability due to its 2014 overexpansion. Direct comparisons of financial statements are complicated by different business models and accounting standards.  HK real estate development revenues are recorded at completion while Xinyuan reports revenues when sales satisfy certain criteria. HK real estate investment property is recorded at fair value while Xinyuan reports investment property at cost. Some companies are holding a significant amount of investment property while others have none. Some companies conduct significant business through joint ventures which are recorded in the financial statements as a single equity entry rather than consolidated into revenues and expenses. Considering these factors, I believe that two measures provide insight into management performance:

1. Gross Margin reflects skill in project selection (location/timing/positioning), development, and marketing. Higher is better.
2. Operating Expense (Selling General & Administrative) reflects management discipline and provides insight into how much gross profit will flow through to Net Income without distortions such as property valuation gain/losses, equity in JVs, foreign exchange, and other volatile or non-recurring factors. Lower is better.

Xinyuan’s gross margin has been below average, but the gross margin estimates of active projects as of 12/31/16 and prudent selection of new projects provide strong confidence that margins will recover to meet or perhaps exceed peer averages. Xinyuan’s expenses are close to average so improved gross profit should flow through to improved net income and remove any remaining rationale for Xinyuan shares to trade at a discounted valuation.

Credit Comparison. Xinyuan’s interest expense and financing terms improved significantly in the past 18 months, but the company’s credit remains weaker than peers:

Xinyuan’s significant assets outside China provide diversification of market exposures and jurisdictions that should reduce some credit risks relative to the peer companies, but Xinyuan bond price levels do not seems to reflect this. When Shenzhen developer Kaisa Group defaulted in 2015 early indications were that holders of the company’s US$ bonds could be significantly disadvantaged relative to domestic creditors. A consensual restructuring agreement was eventually reached and the rights of Kaisa bond holders were not tested in Chinese courts.

If Xinyuan’s strong current cash position cannot be deployed in near-term land acquisitions then paying down debt to reduce interest expense and improve credit quality is an attractive alternative.

Payout Ratio. In fundamental terms a dividend transfers value, but does not create value. However this transfer can have two significant benefits:

• Governance. Investors in Chinese securities sometimes doubt whether the controlling shareholder will truly share the benefits of his company’s growth and value with minority investors so a meaningful dividend payment is a good governance signal. The China Securities Regulatory Commission is even pushing for all listed companies to pay dividends (LINK)
• Realization of Fair Value. If a company has significant value not reflected in its share price then a large dividend returns a portion of that full value at no discount. For example, a Xinyuan investor can now buy shares at 31% of book value, receive dividends paid at 100% of book value, reinvest at 31% of book value, receive more dividends at 100% of book value, and significantly compound his long-term return. It’s the same as the accretion from share repurchase, but with a greater degree of investor control.

2016 Payout ratios from Xinyuan and peers:

Xinyuan’s bond indentures limit combined annual dividends + buyback to $50mm. The company delivered $50.2mm in 2016 (most likely exceeding the annual bond limitation by using a carryforward of unused allowance from 2015). The high payout ratio provided a strong governance signal and also a significant financial benefit to investors by returning a portion of the full book value which they are able to acquire in the market at a large discount.

Investor Communications. A company which effectively communicates its strategy will increase investor confidence and decrease the perceived risk of holding its securities. Most of Xinyuan’s peers communicate in these forms:

• Chairman/CEO letter. The controlling shareholder will exercise the dominant influence over major strategic decisions. The letter in the company’s Annual and Interim reports can share the Chairman’s vision for company development, his/her perception of market challenges/opportunities, and provide valuable insight into a company’s long-term potential. Some companies also provide a helpful illustrated overview of company operations.
• Results Presentation. An easily read summary of highlights from the past year’s activity and future outlook.

• Newsletter. Most Hong-Kong listed developers provide a monthly update on contract sales and any significant corporate developments beyond those requiring mandatory regulatory disclosure. Real estate development is a capital intensive business and a monthly newsletter is a means to maintain ongoing confidence of capital market participants.

Ticker	Company	Chairman/ CEO Letter	Results Presentation	Monthly Newsletter	Equity Analysts (#)
1030	Future Land	Yes	Yes	Yes	2
884	CIFI	Yes	Yes	Yes	10
1966	SCE	Yes	No	Yes	9
1628	Yuzhou	Yes	Yes	Yes	13
1813	KWG	Yes	No	Data only	18
832	Central China	Yes	Yes	Yes	4
1777	Fantasia	Yes	Yes	Yes	2
XIN	Xinyuan	No	No	No	0
Sources: Companies, Koneko Research

Absence of communication from Xinyuan likely increases the perceived risk of investing in the company and has an adverse impact on its share price. Further comments in the next section…

Long-Term Value Generation. Share prices are moved by many factors beyond management control and near-term valuation may have no impact on a controlling shareholder with no intention of ever selling shares. The perspective of the controlling shareholder is best measured by long-term appreciation of book value (plus dividends). Book value is a reasonable measure of fair value as property development assets deliver retained earnings and property investment assets deliver valuation gains/losses (subject to some accounting nuances).

Despite the multiple adverse impacts of Xinyuan’s 2014 overexpansion, the company has still generated long-term return close to peer averages and superior to Henan-based Central China.

While Xinyuan is the primary focus of this article, it’s worth noting that Yuzhou delivered the highest long-term return, has outstanding investor communications, a high payout ratio, strong credit, and excellent profitability. The Chairman signaled a favorable opportunity in January with his insider buys (see 01/04/17).

INVESTOR RELATIONS

Access to capital on attractive terms can play an important role in the success of a capital intensive real estate development business. Xinyuan is at a disadvantage relative to some peers due to its higher cost of debt and very weak share valuation. Unfortunately the company’s investor communications significantly lag peers. Areas of possible improvement:

• Chairman’s Letter. Sailing the seas depends on the helmsman. Chairman Yong Zhang and his wife own 41% of Xinyuan, but shareholders do not receive insight into his thinking. An annual letter would be one way to share this information. The company’s Chinese website has a brief letter, but it has no real content.
• CEO Letter. CEO Lizhou Zhang joined the company in 2016 and has provided opening remarks on company conference calls. He has recently been widely quoted in Chinese media (example) regarding opportunities to integrate new technologies in real estate project development and urban planning, but none of these insights have been shared with Xinyuan investors.
• Presentation. Most peers find a way to get this done.
• Newsletter. A monthly newsletter would be especially valuable for Xinyuan as it is not easy for US-based investors to stay abreast of company and industry developments. A newsletter could share company news that enhances understanding of the business, but does not involve premature disclosure of material information such as financial results. Sample topics could be land acquisitions, community resident events, sales launches, industry awards, media recognition and so on. Some of this information is already covered on Xinyuan’s Wechat channel, but many investors probably don’t follow it.
• Analyst Coverage. It is difficult for Xinyuan to attract analyst coverage in the near-term due to use of different accounting from HK-listed peers and no prospect of lucrative equity underwriting deal fees. However, the company’s own investor relations effort could replace some of the value created by analysts by providing more context for understanding quarterly earnings reports and explaining any unusual items. Not all such details will be favorable to the company, but better investor understanding will reduce perceived risk and create potential for a better share valuation.

The current approach to investor relations costs the company money (through higher cost of capital and lost opportunities) and costs the shareholders money through lack of a fair valuation for investors who wish to sell at any particular point in time. A recent glaring example of Xinyuan’s poor communications was the long delay in announcing Board of Directors approval of a a new $40mm share repurchase plan. Excerpt from page 168 of the recently filed 20-F:

I don’t think the company had a regulatory obligation to make further disclosure, but this is the kind of thing that investors want to know. It was mentioned on the KonekoResearch Twitter account on 04/05, but many investors probably don’t follow it. The company finally put out a press release on 04/18 and Xinyuan stock jumped >6% that day.

Xinyuan has a lot of staff involved in some way in investor relations and some of these people have been very helpful to me so the opinions in this section are not intended as criticism of their individual abilities or job performance, but I believe that Xinyuan’s senior management has not recognized the benefit that would come from a more informative and proactive investor relations program.

BUYOUT POTENTIAL

Diminished investor relations draw attention to a pattern of facts in common with other US-listed Chinese companies that have received management buyout offers:

• Deep discount to peer valuations (increasing the potential return from a buyout)
• Improved corporate liquidity (reducing the capital required for buyout)
• Improved profit potential (higher projected margins) not yet reflected in financial statements
• High potential return from new business initiatives
• Private equity firm (TPG) is a significant shareholder represented on the Board of Directors
• Reduced Investor Relations activity (depressing demand for shares in order to lower the buyout price)

Investors evaluating a potential offer should consider these factors:

• Xinyuan delivered a reasonable NAV return over the past 3 and 5 years despite the negative effects of 2014 overexpansion
• Selling now would sacrifice the improved profitability which is evident in the company’s project portfolio and new business initiatives
• Investors have not sought a buyout and the company has no pressing need for a strategic transformation so if management (or any other party) wishes to acquire Xinyuan then it must pay a fair price relative to peer valuations.

With clear visibility into improved margins and profitability there is no justification for Xinyuan shares to trade in the market, or sell to an acquirer, at a discounted valuation. The lower end of peer valuations are currently at about 65% of book value so I believe $8.90/ADS would be the lowest possible buyout price which could be deemed “fair” to shareholders. I believe that shareholders could earn a higher long-term return through the company’s appreciating book value plus additional value not recognized on the balance sheet. I would urge the Board of Directors to decline to consider any buyout offer received with an opening bid below $7.50/share.

If management is not scheming to arrange a buyout then I urge the Board of Directors, Chairman, and CEO to set an explicit goal of eliminating the discount between the valuation of the Xinyuan’s equity and debt relative to Hong Kong Listed peers. A greatly enhanced Investor Relations program could play an important role. Rather than simply disclosing what is legally required, the company could build investor understanding and confidence by finding channels to disclose as much information as possible. I believe these efforts will realize a significant long-term benefit through lowering the company’s cost of capital.

Curiously, management may achieve a stealth privatization if the share price remains at this level and the aggressive share repurchase plan continues. The company’s publicly held shares (excluding insiders and TPG) are worth $138mm (based on $4.71 share price) and the company just approved a new $40mm share repurchase authorization. Buyback is limited to about $25mm year by bond indentures so all of the publicly held stock could be retired in less than 6 years.

NEAR-TERM OUTLOOK

The value of Xinyuan’s business is solid, but it’s very difficult to predict how much will be recognized in individual periods due to China’s intensifying housing market restrictions. The government has a strong desire to limit real estate speculation and related misallocation of national resources, but it’s hard to restrain demand when Nominal GDP and Money Supply are both growing at annual rates over 10%. Over 60 cities have now implemented mortgage and residency restrictions to limit buying power. Heavy handed regulations are also delaying approval and/or limiting prices of pre-sales of projects under construction.

During the third quarter conference call  Xinyuan CFO Helen Zhang explained that the company was intentionally delaying sales launches on some projects (Kunshan, Tianjin, Zhengzhou) where the market value was above the maximum selling prices permitted at that time under new rules.  During the fourth quarter conference call Helen Zhang explained that 1Q17 sales were expected to be about the same as 1Q16, but that was dependent on a sales approval from the Zhengzhou government at one project.  If that approval were delayed then a significant sales volume might not be recognized until 2Q17.  These factors introduce greater than normal uncertainty into short-term results, but they also reflect the fact that Xinyuan is now well-positioned with projects in strong markets.

Xinyuan is in a fortunate position of having a significant amount of commercial space ready for sale that is not affected by housing market policies. Retail stores have high value after the apartments have been sold and residents are moving in. Company results do not break out the revenues, sales volume, and ASP of commercial space, but some company data provides insight into Helen Zhang’s comments about near-term sales:

Project	Value Remaining	Space Remaining	Commercial Space/ Total Space (sqm)
Chengdu Family	65%	31%	34764/211381
Shanghai Palace	38%	20%	12098/57778
Beijing Xindo	16%	8%	38530/133050
Changsha Splendid	50%	25%	22205/251754
Xi’an Metropolitan	53%	27%	83583/290663

The commercial space in these advanced and completed projects can be sold at high ASP in coming quarters. The 20-F also indicates that 51000 sqm at four projects under construction will be retained for long-term investment. Under Hong Kong reporting an income statement gain would be recognized when that space is transferred from Property Under Development to Property Held for Lease. In Xinyuan’s case the value will be evident in the rental yield, but the company will not recognize a gain under GAAP.

Preliminary data compiled independently by CRIC suggest that Xinyuan had strong sales in 1Q17 (see 04/04/17). Xinyuan GAAP results may or may be similarly positive. Quarterly income will reflect management’s strategy for coping with the multiple challenges presented by current market conditions The detail and clarity of investor communications about this strategy may have a strong influence on market perceptions.

RISKS

Xinyuan’s very low valuation implies a very high degree of risk. Investors may pay particular attention to these factors:

Policy. Chinese government intervention in the property market has risen and created greater uncertainty for market participants. Policies may temporarily or permanently reduce the profits that Xinyuan can earn.

Estimates. References in this article to improving profit rely to a significant extent on the company’s estimates of project margins disclosed in the 20-F filing. These estimates may prove incorrect.

Valuation. Xinyuan shares may continue trading at a very large discount to their fair value and this discount could even increase.

Company Strategy. Xinyuan management may make mistakes. New business initiatives could be unsuccessful. The company could buy land at poor prices or locations. The company could fail to buy enough land to support the scale of the current business.

Buyout. References in this article to the potential for a buyout are based on a pattern of facts in common with other US-listed Chinese companies that have received privatization offers rather than any specific indication that a buyout is being considered by Xinyuan. Many of these buyouts paid shareholders less than the fair value of the businesses.

Author’s Interest. The author is a Xinyuan shareholder and believes that greater public awareness of the facts in this article could be of benefit to himself and other public shareholders. Investors are encouraged to check all of the key facts cited here from SEC and HKEX filings prior to making their own investment decisions.  The author is also a shareholder of Yuzhou Properties.