Among the stocks I follow, Xinyuan Real Estate Company (XIN) distinguishes itself as an extremely cheap stock. While its book value stood at $6.25 at the end of Q2, the stock is selling at $3, climbing up from the recent low of $2.50. There might be many reasons one can think of to justify the difference, but the 50% discount looks very perplexing for a company that is making positive earnings and its assets contain mainly real estate under development and cash.
I can think of two reasons that could possibly cause the huge difference:
This company is a fraud
China real estate is overheated; it is going to crash and burn.
In this thesis, I would like to review Xinyuan’s business and then discuss how unlikely these two possibilities are.
Xinyuan’s Business
According to Yahoo Finance:
Xinyuan Real Estate Co., Ltd., through its subsidiaries, engages in residential real estate development business, as well as provides property management services in the People’s Republic of China.
Xinyuan focuses on developing properties in the second and third tier city market in China, and its strategy is not to get involved in the land holding, but rather fast real estate development and fast sales.
Xinyuan was properly IPOed at the end of the year 2007 at $14 per share, collecting $229m after expenses. Its leading underwriter was Merrill Lynch, and its auditor is Ernst & Young.
Very few Chinese real estate-related companies are listed in the U.S. market. We have E-house (EJ), a real estate sales agent company, and China Real Estate Information Company (CRIC), a real estate information and commercial company listed. Recently SouFun (SFUN), a real estate marketing company successfully IPOed on the Nasdaq. Its stock priced at the top of the offer range and jumped 73% on the first day of trading.
In this sector, Xinyuan is nearly the only one that does house developing in China. This listing is a little odd as the major players in this market such as Vanke and Poly are listed in the China A-share market, while companies like Evergrade and Sino-Ocean are listed in the HK market. China A-share market and HK market investors understand the Chinese homebuilders much better and thus become the ideal places for listing. Listed in the States, Xinyuan looks like an orphan. But here may be where mispricing comes into play.
Xinyuan Financials
Here are some basic data for this company for the quarter ending in June.
Outstanding ADR count: 76m ADR
Stock Price: $3.0/ADR, compared to book value of $6.25/ADR
Market Cap: $228m
Real Estate Under Development: $636m, or $8.4/ADR
Cash: $167m, or $2.2/ADR
Debt: $326m, or $4.3/ADR
Equity $475m, or $6.25/ADR, compared to the stock price of $3.0/ADR
Gross Margin: 21%
Net Margin: 9.4%
The bulk of its assets are in real estate under development and cash, and there is no goodwill or intangibles. If the financial statement is believable, this company is selling at a huge discount. If we buy this company, it is like buying housing in China with 50% discount.
However, Xinyuan’s stock price almost never performed very well in the past three years. It has spent most of its time trading down except for the first half of 2009, in which it traded up from $2 to $7. So where is the problem?
Can XIN be a fraud?
We are all aware that there have been many Chinese stock fraud cases being exposed, which also caused the multiples for Chinese small cap stocks to shrink rapidly. Some frauds have been very sophisticated that they fooled the author as well. However, if we can find one legitimate one, we may be able to buy legitimate company at really attractive valuation.
For Xinyuan, I have the following evidences to work against fraud:
Merrill Lynch brought XIN to the market.
Ernst & Young audited its book and issued unqualified opinion to BOTH its financial statements AND the effectiveness of its internal control. We are yet to discover a Chinese company having met this qualification but also committing fraud.
It has been listed on the NYSE for nearly 3 years.
Its properties and related news can be easily tracked down with reputable Chinese real estate websites, such as SouFun, Sina (SINA), and Sohu (SOHU).
Its IPO proceeds, $229m, is already more than its current market value, $228m.
It did have rough years through the financial crisis, and it had to write off part of Suzhou project in the first quarter of 2009 to reflect the overpaid land price. But the China real estate market has been strong so that the same Suzhou project is more likely making even. Overall XIN has been making profit for each of its past projects.
It did have hardship under the government regulation. While Xinyuan’s second quarter results got off to a strong start in April, the government policies issued in mid-April resulted in a significant reduction in sales at many of Xinyuan’s projects in May and June.
Even though there is constant fear of a Chinese small cap being a fraud, Xinyuan does have a low chance of being one.
Is China’s real estate market going to bust?
I am not into the debate of whether China’s Real Estate market is going to have a severe problem in a few years. But what we do know is that the real estate market saw an increase in price and volume for the past August and September.
Even if we write off 10% of the book value of Xinyuan out of a pessimistic economic view, we are only down by 84 cents per share. We still have a book value of $5.4, much higher than the current market price. In other words, the margin of safety is high.
What is more, this company has gone through some difficult times already and has proven that it can survive under adverse environment.
Communications with the management
With the book value discrepancies in mind, one natural thought coming up is that someone can really do an arbitrage trade on this, preferably the management. If the company is willing to shrink the operation and use the saved working capital for the purpose of stock buyback, we should see immediate effect on the stock market price. Of course that is just a thought, and a good management, if doing things right, should just stick to their practices and increase the value of the company, disregarding the short term stock market price. This is exactly what I have found in terms of the management.
Tom Gurnee, XIN's CFO, has been very open to questions. So far the company is mostly paying attention to how to use the cash correctly in responding to the government policy changes. Late 2009, the company purchased new lands for new projects after the financial crisis, but the government again tightened the policy in April/May to curb the rapidly rising housing price, so the company is again on the cautious front not to spend on expanding into new projects. However, the company is not thinking of any stock repurchase to arbitrage the difference between its book value and the market price.
Tom also mentioned that one fund invested in the company is due to winding up and distribution by the end of this year. Even though the fund is not ‘desperate’ to unwind its position, the fund may not be price elastic nevertheless. Tom believes that once the overhang is over, the market is going to price the stock correctly.
Valuation
No fancy formula is used to value Xinyuan. Based on my understanding of the Chinese real estate market, I believe that the book value, $6.25, should be a very conservative valuation of the company. The NPV of this company is roughly at $7 to $7.25, assuming 10% net margin out of the current properties in development. P/E or EV/EBITDA, or even DCF may not be a good method in valuing Xinyuan since the real estate sales can be affected by the government policy greatly.
Catalyst
Based on the conference call of the last quarter and the recent real estate development in China, I expect the earning numbers for the next quarter should be a good one.
Disclosure: Long XIN
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