- Contract sales have been strong – unsold inventory is at a multi-year low
- Gross margins have been satisfactory – estimated 28% for projects under development
- 75Bn RMB (>$11Bn) Xinchuang Technology investment plan could transform the company.
- Leverage must decrease – ratings outlook is negative and XIN bonds are yielding 18%
- Property Management subsidiary is preparing to list on the Hong Kong Stock Exchange
- Insiders sold shares in 2017. Poor investor relations may result from poor internal communications.
Xinyuan Real Estate (XIN) shares have fallen 55% from their 52week high, slightly worse than the average 45% drop for HK/US listed Top100 China real estate companies. Xinyuan operating results have been reviewed in several recent Seeking Alpha articles and further details are in the 2Q18 Press Release, Conference Call transcript, and Mid-Year Financial Statements.
The share price weakness reflects current challenges of confusing accounting, weak profitability, and excessive debt, but the company has not communicated major developments to shareholders that could significantly enhance future returns. The Xinchuang Technology investment plans totalling over 75Bn RMB provide the Xinyuan Group with access to a large supply of low-priced land in attractive markets and reduce future dependence on real estate market cycles.
This article does not make any recommendation regarding investment in Xinyuan. Investors may use the information in this article to demand better company disclosure about Xinchuang and other new business initiatives. For company background information see the Annual Report, company website, and Investor Presentation.
CONTRACT SALES HAVE BEEN STRONG
Adoption of ASC606 and a change in the language of Xinyuan buyer contracts created a confusing blend of revenue recognition treatments, but ultimately these are just timing differences. Once each apartment has been delivered to a buyer the final revenue and income are the same under every treatment. See the company press releases and articles by other authors for more detailed accounting analysis. This article will focus on underlying business trends.
Progress of Xinyuan’s business is best measured through contract sales which are estimated to have remained strong through 3Q18:
Pace of Sales: Xinyuan’s goal is to achieve cumulative cash flow breakeven approximately 7 quarters after a project begins development (see presentation page 7). Successful projects will sell quickly and cash received from customer deposits (downpayment + mortgage) will cover the remaining construction costs without drawing on corporate financing. Excellent sales performance in recent quarters left Xinyuan’s unsold inventory at 6/30/18 at a multi-year low:
Most of Xinyuan’s projects are close to sold out with only the Xinyang Splendid II holding some aging inventory. Even the most recently launched projects have already recorded substantial sales.
GROSS MARGINS IN CHINA HAVE BEEN SATISFACTORY
The average gross margin calculated for percentage of completion accounting has remained in a healthy range (details are in the mid-year financial statements).
The range of estimated gross margins from active projects shows slight weakening due to mediocre returns expected on some newer developments (ZZ Intl New City 3A 3B 3D, and ZZ Fancy City 2N)
Over the past year Xinyuan has joined partnerships with other real estate developers for certain projects as detailed on page 7 of the Investor Presentation. Clarification was sought from Xinyuan Investor Relations about whether these projects would be consolidated in Xinyuan financial statements or reported as an equity entry, but no answer has been received.
XINCHUANG TECHNOLOGY COULD TRANSFORM THE COMPANY
The Xinchuang Technology business (a 100% owned subsidiary) is described in the Investor Presentation as “industrial real estate”, but a literal translation of the Chinese description as a “technology town operator” is more accurate. Xinchuang is planning and building business communities with offices, research space, residential buildings, and common commercial and business services. The goal is to catalyze clustering and networking effects similar to Silicon Valley or the North Carolina Research Triangle.
The huge land area secured for development is an early indicator that this business may become very successful. Xinyuan’s Investor Presentation (page 6) says that “Xinchuang Technology has also entered into official agreements with several government authorities and has locked in a total land area of 29,627 mu“. A “mu” is a Chinese unit of measure equivalent to 666.7 sqm. Xinchuang’s “locked in” land area is equal to nearly 20mm sqm and over four times bigger than Xinyuan’s disclosed “landbank” of 4.9mm sqm at 12/31/17.
Xinyuan has acknowledged only two of the official agreements to investors, but at least 6 more have been publicized in China by Xinyuan, Xinchuang, government authorities and Chinese media. An additional four developments are briefly mentioned on Xinchuang’s website, but I cannot find any confirmation whether there are agreements in these cities, or perhaps just proposals, or maybe just aspirations.
Basic information about most of these projects is provided on the Xinchuang website. Example:
Xinchuang and Xinyuan boldly promote progress on these projects in China, but disclosure to shareholders has been minimal. The Annual Report and Mid-Year financials do not even mention the existence of this business. If land area of 29627 mu is “locked in” then it is very likely that large corresponding planned investments must also be “locked in” and should have been disclosed in SEC filings.
Government Relations are critical to the success of this business. Local government officials are responsible for developing the size and quality of the economy in their jurisdictions. Residential land use rights in desirable locations are normally sold through auctions to generate maximum revenues for for municipal services. However Commercial and industrial land can sometimes be sold at favorable pricing to companies that will bring new business to the area. This could be a large employer, but it could also be a real estate developer such as Xinchuang if it can present a compelling plan to create a business community that will attract successful enterprises. This article describes continuing Zhengzhou government involvement and support for Xinchuang’s Hangmei project including rent subsidies and maintenance of an on-site government office to expedite licensing and other regulatory assistance.
Competition. The potential to cheaply acquire land use rights makes this type of development very appealing and many companies are competing for these opportunities. Xinchuang received an impressive recognition of its success at an industry conference last summer when it was ranked among the “TOP10 Science and Technology Town Operators” alongside well-known technology and commercial real estate firms:
Xinchuang’s Competitive Strengths:
- International Partnerships provide Xinchuang community members with introductions to global opportunities (e.g. Xinchuang Ireland Science and Technology Center, Israel Science & Technology Center, London Technology Week)
- International Business Partnerships (e.g. IBM AI Innovation Center, Oracle Training Center, Tencent AI & Health Technology Center)
- Educational Partnerships (e.g. Cambridge Tsinghua, Macao University)
- Conferences provide networking and visibility for Xinchuang community members (e.g. Silk Road Forum in Huzhou, Health Technology Forum in Beijing)
- Technology Industry Connections cultivated through Xinyuan’s own technology ventures (AI, Cloud Computing, Blockchain). Even if those businesses do not become independently successful, having that in house expertise should be enormously beneficial to XInyuan in designing successful communities.
Xinchuang’s locations are suburban sites near attractive Tier-2 cities. The Zhengzhou Hangmei project is near the airport, about 30km from the city center.
The Dalian project is also about 30km from downtown:
These locations provide the advantage of large sites at extremely favorable prices. The first section of land use rights in Dalian for research use cost only 541RMB per buildable square meter and the first residential section cost 1036 RMB/sqm. If Xinchuang builds a successful community then each subsequent phase of development will become more valuable, but access to land is already locked in. if Xinchuang fails to attract businesses then a site may become a ghost town.
- Landbank: The Technology Towns can secure land use rights to satisfy many years of future development for Xinyuan Group. Xinyuan will be much less dependent on continually acquiring new land through competitive public auctions. Ability to access “locked in” land use rights when needed will reduce cyclical risk.
- Multi-Use: The residential portion of the towns is likely to be the most profitable segment and is not substantially different from the development business that Xinyuan has conducted for many years. The first residential phase of the Zhengzhou project began presales in May 2018 and is forecast to earn an attractive gross margin of 28.6% (link to project at Fang.com).
- Multiple Phases: Each project is likely to be built in multiple phases over 5-10 years. Proceeds from earlier phases and residential units will provide capital for later phases and commercial space that may be retained for long-term investment.
- Funding: The cumulative investment is likely to be greater than 75Bn RMB because the table above is incomplete and Xinchuang is seeking new agreements. A portion of the funding may come from equity partners and tenants. Xinyuan has barely explained to shareholders that the business even exists so it has certainly not provided any insight into sources of financing.
- Profits: A TOP10 position in this niche business provides Xinyuan with the opportunity to enhance its brand image and earn higher returns than are available in highly competitive residential development. A locked in supply of low cost land enables higher long-term margins, but it requires successful nurturing of these specialized business communities.
Clarification was requested from Xinyuan Investor Relations about the following topics (in some cases more than once) and no answers have been received:
- What is meant by “locked in” land area?
- What is the plot ratio and buildable sqm for the “locked in ” land area?
- What percentage ownership does Xinchuang hold in each development? XInyuan investor relations says the company holds 100% of Zhengzhou Hangmei, but the 20-F says a 49% non-controlling interest is held by a third party (Xinzheng Meihang Network Technology)
- What is the current status of each development?
- Does Xinchaung have active projects in Beijing Shanghai and Shenzhen as mentioned on its website?
- Does Xinchuang’s large land area and investment plan mean that it will be the primary vehicle for Xinyuan’s long-term growth?
XINYUAN MUST DELEVERAGE
Xinyuan’s leverage (non-cash assets/equity) is much higher than peers and Fitch recently revised the company’s ratings outlook to Negative (Fitch announcement). Xinyuan’s US Dollar bonds due 2019-2021 are trading at yields where refinancing would be prohibitively expensive.
Xinyuan added considerably to its landbank during strong market conditions of 2017 and 1H18 in a belief that a larger land reserve would provide greater visibility to lenders and improve access to financing. So far it does not seem to have worked. Fitch disclosed that “The company does not plan to acquire land in 2H18 or 1H19”. The land market has weakened in recent months offering potential bargains for patient and well-capitalized buyers (not Xinyuan).
Comparing Xinyuan against the peers profiled in Three China Real Estate Bargains:
China South City and Modern Land are also B-rated real estate companies with bonds yielding over 15%.
Xinyuan’s active projects have sold well so a large part of their development cost has been financed with presales (shown on the balance sheet as “customer deposits”). Xinyuan’s balance sheet is burdened by a large inventory of space at completed projects with a cost of about $60mm/year ($710mm carrying value at 8.37% 1H18 average interest rate).
Xinyuan’s $1.9Bn of short-term debt is substantially covered by $1.5Bn of cash+investments, but the company needs to deleverage in order reduce interest expense, refinancing risk, and put itself in a better position to make long-term investments.
Despite the low stock price, share buyback is not an attractive use of funds right now compared to repurchase of outstanding bonds using the $50mm authorization approved in August. Bond repurchase captures a gain on extinguishment of debt and reduces leverage. Share repurchase would be accretive to book value, but also increase leverage.
Clarification was requested from Xinyuan Investor Relations as to whether the Fitch statement about 2H18/1H19 land acquisitions was correct, but no answer has been received.
Clarification was requested several times from Xinyuan Investor Relations regarding company plans to sell aging inventory in Beijing and Shanghai, but no answer has been received.
INSIDER OWNERSHIP & GOVERNANCE ISSUES
As a “foreign private issuer” Xinyuan and its executives are exempt from SEC requirements to report transactions in Xinyuan securities, although large shareholders such as Chairman Zhang are still required to file and amend forms 13 D/G. Ownership disclosures in the annual 20-F filings show that 5 insiders made substantial sales during 2017 and 5 held no shares at year-end.
Non-shareholding directors participate in making major decisions affecting shareholders without sharing in the consequences. With Xinyuan stock trading at a 2-year low investors are justified in questioning whether these Directors have gained enough confidence to purchase shares.
Xinyuan’s poor communication with investors about Xinchuang and other new business initiatives may result from poor communication with the company. Xinyuan’s Investor Relations function is managed by its accounting department. Staff there may not be aware of what is happening at the new businesses which are not yet moving cash and creating balance sheet assets and liabilities. During 2017 former CFO helen Zhang was unable to explain the company’s blockchain research and Xinyuan lost the opportunity to ride the related market enthusiasm and raise equity at an attractive valuation, a huge blunder. The accounting department knew how much capital had been advanced to the blockchain subsidiary , but may not have had any idea how that money was being used. Xinchuang has signed agreements that “locked in” a huge land area and this appears to be a material development, but the only cash movement and accounting entries required so far have been small payments for the first allocation of land use rights in Zhengzhou. If this theory of poor internal communication is correct then this suggests a management and governance problem that needs to be addressed at a senior level. Better communication within Xinyuan would result in better communication with investors. If this theory is wrong and the accounting department has been well-informed about all corporate developments then they have just been doing a poor job of investor relations and that should be addressed by senior management.
Longtime China accountant Drew Bernstein of Marcum LLP recently summarized the “
- “Powerful Investment Thesis – Your company needs to have concise, powerful statement as to why your equity is a promising investment”
- “Complete Management Team – You will require a CFO who is experienced in US GAAP or IFRS accounting, understands SEC reporting requirements, and has prior capital markets experience.”
- “Reliable, Timely Financials – poorly disclosed transactions erode investor confidence”
- “Attainable Business Milestones – Management teams that tell investors what they plan to do, and then consistently hit those marks on or ahead of schedule will see rising share prices and premium valuations.”
In a recent Chinese media interview Xinyuan CEO Zhang disclosed that the company’s property management subsidiary, Xinyuan Science & Technology Service (XSTS) was preparing for a HKEX listing in 1-2 years. Koneko comments on the unit’s strong 1H18 results, current NEEQ listing, and fair value were provided here. It looks like XSTS will benefit from an agreement signed earlier this year enabling dual-listing of NEEQ firms in Hong Kong.
Based on comps already listed in Hong Kong, the fair value of XSTS is in a range of US$69-197mm.
In conjunction with an HK listing XSTS would probably issue new shares equivalent to 25% of total capital at the low end of comp valuations. In time the shares should appreciate to the middle of comp valuations and potentially serve as currency for accretive acquisition of new property management contracts.
The goal of an HK listing appears to be a material positive development that should have been disclosed to shareholders.
QUESTIONS FOR 3Q RESULTS
The 2Q18 conference call brought a welcome change with participation of Chairman Zhang and CEO Zhang in the Q&A segment. Hopefully they will comment on the following topics in the 3Q18 call during prepared remarks or in response to investor questions.
- Contract sales performance relative to guidance and reasons for outperformance or underperformance
- What is the balance of contract sales that have not yet been recognized in revenue? When will those sales revenues be realized?
- Has the company seen easing of housing market regulations in any of its markets?
- Has the company seen evidence of price declines or discounting in any of its markets?
- Has the company repurchased any bonds?
- What is the company’s land acquisition plan?
- What is the status of the Xinchuang Technology developments and how will they be financed?
- Has the company been able to dispose of any non-core assets and reduced its inventory of completed properties?
- Is the Property Management business preparing for a HK listing?
- How does the company plan to satisfy its debt obligations maturing over the next twelve months?
- Have senior management and directors purchased any shares or do they have any plan to purchase shares?
Compared to leading peers Xinyuan trades at a lower price/book ratio, but has higher leverage, weaker profitability, and has delivered lower long-term returns (see Three China Real Estate Bargains).
If Xinyuan were able to improve its profitability to peer levels then its shares should appreciate substantially to match peer valuation multiples. Xinchuang could provide a foundation for future success, but minimal disclosures make it difficult to assign any value to its future potential.
The high yield-to-maturity of Xinyuan bonds implies significant credit risk. A slowing China economy is leading to a broad policy easing which should relax refinancing pressure on lower-rated property developers and support sales in the Tier-2 cities where Xinyuan does most of its business. If policy easing is not sufficient to stabilize China’s economy then Xinyuan will be a risky holding.
This article did not review Xinyuan’s New York projects. The Oosten property in Brooklyn has turned into a money-loser due to a huge cost overrun. The Midtown project faces a weakening Manhattan condo market.
DISCLOSURES AND NOTES
At the time of publication the author is a shareholder of Xinyuan, Guangzhou R&F, and Yuzhou Properties. The author does not make any recommendation regarding any investment in any company mentioned here. Investors should check all of the key facts cited here from regulatory filings and other public sources prior to making their own investment decisions.
A copy of this article was sent to Xinyuan Chairman Zhang, CEO Zhang, CFO Li, and Audit Committee Chairman Gurnee with a cover letter requesting the following measures be implemented as soon as possible:
- Review of all Xinchuang contracts and public statements to assess whether material commitments have been made requiring disclosure to shareholders
- Setting policies to ensure that public disclosures of material developments and forward looking information are not made in China or to unaffiliated parties without simultaneous disclosure to shareholders
- Elevating the awareness of investor relations within the company to ensure that staff are well-informed about business developments and future goals so that these can be communicated to investors when there is a benefit and/or obligation.
- Review of ownership of Xinyuan shares by executives and directors
A link to this article was sent to Xinyuan Investor Relations. If the company can point to factual errors in the article using information public as of 10/25/18 then corrections will be made as promptly as possible.