Comments on Xinyuan Real Estate Ahead of 3Q17 Earnings

Xinyuan will release earnings on Friday 11/10 (announcement and webcast link).  This article covers some background information that may be of interest to investors:

• Notes on 1H17 financials
• What to look for in 3Q results
• Benchmark valuations

Financial Notes (project costs, gross margins, interest, tax, and book value per share):

Xinyuan released 2Q earnings in August which featured strong sales performance, but a disappointing bottom line (see Koneko commentary) .  Some additional details are available in the Financial Statements and MD&A filed on 09/20/17. Key points:

Rising project costs related to revenues booked in prior periods adversely affected 1H17 net income by $15.9mm ($0.12/share).  The MD&A explained:

Similar adjustments have always been applied in past periods, but were usually positive and suggested that estimates were conservative.

The negative revision in 1H17 is not good news, but helps to explain the company’s weaker than expected profitability during a period of strong sales.

Oosten costs are higher than expected and Xinyuan has realized a gross margin of only 11% on $237mm of Oosten sales to 06/30/17 and is now engaged in legal disputes with both the contractor and architect:

Participation in the Oosten project undoubtedly enhanced the image of the Xinyuan brand in China.  Hopefully the experience gained from this project will lead to a better financial return from the Manhattan and Queens projects now under development.

Income statement gross margin from Chinese projects improved to 24.9% in 1H17 while estimated gross margins from active projects declined to 27.3%

1H17 earnings were depressed by higher than normal interest expense of $29.7mm, but capitalized interest declined from recent levels:

It may be that higher expense over the past 12 months was a frictional cost associated with  accumulation of cash for redemption of the older bond issues.

Xinyuan’s cost of RMB financing declined slightly in 1H17 due to greater use of bank loans.  The company’s new 3 year onshore corporate bond issued in April carries an 8.2% coupon which is relatively high, but it was probably prudent to take that opportunity to extend the average maturity of the company’s borrowings.  Each bond issuance also requires regulatory approval which may not be available during periods of policy tightening.

The effective tax rate in 1H17 rose to 59%, but the financial statements do not contain any explanatory details.  The rate has been volatile over time.

It may be that the higher rate in recent periods is the result of reporting taxable income in China and losses in tax havens.  Note that the peer comparison later in this article shows several other companies have been paying similarly high rates.

Book Value per share rose to $14.13 at 06/30.  Accretion from the share buyback during 2Q17 was more than offset by dilution from issuance of shares in equity compensation.  The company repurchased 2.3mm ADS in 1H17, but also issued the equivalent of 1.6mm.

What to look for in 3Q results and management commentary:

3Q17 Contract Sales guidance of 4Bn RMB was provided in the 2Q17 call.  CRIC estimates and strong sales at several projects should enable the company to meet this target as described here.

4Q17 contract sales guidance should be provided with 3Q results (unlike all competitors XInyuan has not previously released a full year target).  It will be helpful if management can share some details of which projects will make the largest contribution to 4q sales and any factors that may affect the timing of sales launches.  For example, the company may receive sales permits earlier or later than expected and the company may accelerate or delay sales depending on market conditions.

Inventory clearance would reduce the company’s financing requirements.  Three projects are worth watching.  Oosten was being carried at a cost of $149mm at 6/30/17.  Shanghai and Beijing were a combined $141mm which is almost entirely commercial space.  Both cities implemented new rules making it more difficult for individuals to purchase commercial real estate for investment.

New business initiatives seem to be important to company executives based on media reporting, but minimal description has been provided to shareholders.  It would be helpful if management explains the evolution of the company’s business strategy.  In particular:

• Business Park development.  Xinyuan’s Chinese website features a section describing “City Operation” which displays a rendering of a huge project labelled Zhengzhou Hangmei Technology Town.  Additional pictures are available from the design firm BDCL.  The text discloses that IBM Foxconn and other major enterprises will be participating.  Xinyuan’s wechat recently mentioned that Oracle will also join.The text mentions that in the next 3-5 years Xinyuan will build additional technology parks in other major cities including Beijing, Tianjin, and Qingdao.  CEO Zhang recently met with the Vice Mayor of Tianjin to discuss these projects.  The business opportunity is nicely summarized in this article.  Local governments will award large blocks of land on very favorable terms to developers that are able to deliver a desirable business community.

The limited information available to this point suggests that Xinyuan has negotiated an excellent agreement with the government of Zhengzhou, a market the company knows well, and has been successful in attracting leading enterprises as tenants.  The 6/30 financial statement shows the project is carried at a cost of $8mm and is held by a 51% owned joint venture with Meihang Technology.

If Xinyuan is successful in moving this project forward in Zhengzhou and then building similar large industrial parks in other attractive markets then it would bode very well for the company’s future.  These projects would bring large blocks of land at low cost,  predictable multi-year project paths, enhance brand visibility, and establish Xinyuan as a significant participant in a market that might be less price competitive than residential development.

• Blockchain Robots and ERP Software are new business initiatives that the company promotes in Chinese media, but which have never really been explained to shareholders.  The blockchain research has been conducted in partnership with IBM and Tsinghua University and is described here on Xinyuan’s Chinese website, at this site for the Ruizhuo Xitao subsidiary, and at this site for the FYIXIN consumer lending app released this year.  The robot business is described here on Xinyuan’s Chinese website and on this subsidiary site.  A Singaporean company announced last month that it signed a letter of intent to buy 51% of this business for US$5.1mm, but Xinyuan has not made any similar disclosure.  The ERP software is described here on Xinyuan’s Chinese website.  I understand it has been developed initially for Xinyuan’s own use and will also be marketed to smaller real estate companies.

There is very little information about the technology subsidiaries in the Xinyuan financial statements so the investment to date has likely been modest.  In the absence of any management commentary it is difficult to understand what role these units will play in the company’s future development.  It’s possible that media coverage of these activities is beneficial to Xinyuan’s brand image and can enhance real estate sales.  It’s possible that involvement in these activities is beneficial to Xinyuan during negotiations with city government regarding access to land for large industrial parks.

Xinyuan remains significantly cheaper than comparable Hong Kong listed companies

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 YTD return remains well below peers and its shares remain cheap at just 40% of book value.

Three areas will be examined in more detail:

• Margins
• Credit
• Tax Rates

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.

Note that Xinyuan’s gross margin on China projects was 25%.  The corporate average was dragged lower by New York Oosten .

Credit Comparison. Xinyuan’s credit remains weaker than peers:

Tax Rates vary substantially among companies, but many are quite high and Xinyuan does not seem unusual.  Some companies with lower rates (e.g. KWG) earn substantial income through unconsolidated joint ventures which pay their own tax.

Disclosures:

 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.