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Xinyuan Real Estate Co., Ltd. (XIN) buys land in China, and now occasionally in the US, develops it for residential use, and sells the units as soon as possible, keeping inventories as low as possible. It then recycles the cash to use again on more land purchases.

Bottom Up Analysis

From old correspondence to the SEC, XIN explained how it obtains land through government land sales:

"Proceeds from the sale of land use rights are an important source of funds for a local government's operating budget. We believe that there is pressure for local governments in China to hold more land auctions in the remainder of 2011 and early 2012. Since the second quarter of 2011, we have observed a reduction in land auction prices which have led us to participate in two auctions thus far in the third quarter of 2011. However, we lost both auctions to higher bidders. Nonetheless, in order to maintain a pipeline of land available for development necessary to meet our growth strategy, the Company intends to actively participate in future land auctions in this second half of 2011 and early 2012, assuming that the land meets our land acquisition criteria. "

This land is often actually expropriated from farmers in China for far less than what it is sold for to developers. I have not done the research to determine whether this is the case with the land XIN ends up buying, but even if it's not, the fact that this is occurring anywhere increases the supply of land that the government is trying to unload, thereby lowering the price the government is willing to accept in sales. Therein probably lies the edge for XIN as a Chinese developer: the government essentially takes the property for free, takes some profit for itself by selling much higher, but still sells at prices lower than what a fully competitive market would dictate, leaving fairly high profit for developers.

Peers in Asian stocks trade at 6-8X earnings. XIN trades for under 3. XIN's book value, which should be very close to current market value because we know from the high turnover business model that all assets/liabilities were recently acquired, is ~$11/share. This includes no goodwill or intangibles. This includes a large cash stockpile used to purchase land, and low debt levels. Given XIN's track record of successful development, the ongoing enterprise should obviously be given some value, too. This puts the fair value of XIN at $15+/share, conservatively speaking. While a series of developments have been mostly sold recently, and most of its next round of development is in early stages, the CFO, which otherwise seems to sound conservative about many things, says 2014 profit "should at least be over 150M," or $2/share.

A Roth investor conference is coming up in March 17-20, at which XIN will present. According to the CFO, some new larger potential investors have been listening to them that haven't been listening to them before.

Equity International, one of its former biggest shareholders, sold all its shares in 2010. The XIN CFO says this is because they closed a fund. John Griffin of Blue Ridge Capital owns a bunch of shares.

Top Down Analysis

No matter what, assuming that the chance XIN is cooking the books is small, the share price should be much higher, but exactly how much higher depends in large part on the big macro picture, and I think that consideration warrants an aggressive valuation. "A rising tide lifts all boats," and I believe the top-down view is where a lot of market misunderstanding lies, as well, considering well publicized short Chinese property theses as promoted by hedgies like Chanos. On many fundamental measures, they are correct. However, I believe they are ignoring an extremely important tailwind to home prices brought about by government intervention. As macro traders know, governments cannot control all of: 1) monetary policy; and 2) exchange rates; and 3) capital flows. China has tried for years to control all of them, but the leak in the system has come mostly in capital inflows. This has caused M0 to expand rapidly over the last decade. This money has to go somewhere, and it looks like it's been going into real estate. For as long as China controls the exchange rate at too low a level, capital will flow in, and it will continue to need to find a parking space, so the longer-term fundamentals will continue to be disregarded. Every once in awhile, China increases bank reserves or implements more restrictive measures to home buying. This dampens the money multiplier used to determine M2/M3 money supply from M0. However, this is akin to trying to stop an avalanche by propping up trees. China's M2 supply trajectory has still been steep in spite of these measures. While it's possible that measures are implemented that eventually stymie the money multiplier enough to flatten the M2 curve, I'm not in the business of fighting trends or picking tops, so I can afford to watch the government incrementally tweak the economic system and look for inflection points. In addition, one must remember that the Chinese government has propped up these trees in response to the avalanche, so if the avalanche stops, it will no longer put up trees. In fact, it is leaving itself plenty of capacity to dynamite the avalanche to start it anew if it desires by reducing reserves requirements or removing regulatory obstacles! In the meantime, I intend to be long property. As Soros says, he looks for bubbles, and buys them (with the implicit understanding that he's looking for the bubbles on the way up). I should also note that Hong Kong has recently had to begin printing HKDs again to support the peg with the USD, after a hiatus of a year or two. This inflow into HKDs also has to go somewhere, and the destination could easily include H-shares in REITs possessing property in both HK and the mainland.

Another thing that encourages me to be bullish is that Chinese buyers don't seem to be in the crazed mania mode yet, where they believe prices will go up forever. Among 20,000 residents surveyed by the People's Bank of China in 50 cities in late 2012, only 29 percent of them said they expected housing prices to rise again next year. Also, About 67 percent of respondents said present housing prices were still too high. So sentiment allows plenty of margin for bullishness, as well.

Regardless of what stage in the RE bubble that we're in, according to XIN, most of its home buyers are of the owner-occupied variety, which are less subject to the speculative whims of the capital inflows.

Impact of recent guidelines to enforce 20% capital gains tax on property sales

On March 5, China issued guidelines to enforce 20% capital gains tax on property sales. This will most likely cause real estate prices to drop before the enforcement could take effect as those that want to sell soon expedite the process to avoid tax repercussions, but later contribute to a further pre-tax rise in prices after the enforcement takes effect (assuming it does get enforced) as the market price compensates to maintain roughly the same average prices post-tax as they had been trading. This will have the opposite effect of what the government intends. It will simply limit the volume of properties changing hands by increasing transaction costs, but will actually contribute to price appreciation.

XIN stock apparently got slammed on this news, as did a few other REITs trading in China. However, many REITs holding Chinese property weren't effected whatsoever, and are indeed already trading above prices that they were trading at before the news broke. I see this as a definite opportunity to fade the news and accumulate more XIN shares at better prices. If anything, given where XIN is in the development cycle, where they are positioned to soon deploy a bunch of cash buying land again, this may actually help them, as the land and contractors may temporarily be cheaper.

Fear of Fraud

XIN is probably priced so cheaply due to concern about fraud. To me, at face value, risk of fraud would be higher for Chinese-listed securities than for a US ADS due to extra Sarb-Ox and SEC regulations. XIN's CFO says the company likes being subject to Sarb-Ox because it increases their credibility with investors. Their internal audit department is 11 people deep, and they verify internal controls over XIN's large cash stockpile. I have not personally visited their land sites, but the Williamsburg, Brooklyn, construction site can be seen on Google Map street view. The CFO says that they have considered ramping up PR activity to stave off fear of fraud, but that their focus will never be on pushing out PR. It appears that investor fear of fraud has been dissipating over the last year or two, which will hopefully bring the share price more in line with value.

Mr. Gurnee's former position as audit chair of LongTop, which conducted fraud, is incredible, and probably a big reason for investor's fear to invest in XIN. However, Mr. Gurnee's time appears spread across several corporations, and these other US-listed companies with Chinese operation continue to use his services, so his involvement in LongTop appears somewhat excusable.

Regarding XIN's SEC correspondence, XIN answered all the SEC's concerns to my personal satisfaction in its letter dated Sept 14, 2011. Regarding the 40M note secured at an inflated interest rate of 15.6%, the inability to secure alternative financing may in fact have been in large part due to the market perception of the risk of fraud. The high interest rate in turn perpetrates the fear of fraud, making it difficult for XIN to escape from the circular inertia of this perception.

There are other factors weighing against fraud. XIN's chairman owns 40% of the company, and has had plenty of time to sell some shares if they were bogus. Secondly, the dividend payment yielding over 3.5% would put a lot of cash flow pressure on a company that didn't have the cash they allege they have.

One concern I have about the Ernst & Young auditor is that, like other independent registered public accounting firms operating in China, it's not permitted to be subject to inspection by the Public Company Accounting Oversight Board, and as such, investors may be deprived of the benefits of such inspection. However, considering the recent land purchases in the US, it appears XIN is increasingly subjecting itself to auditing scrutiny in US jurisdiction. While this may be a ploy to try and leverage credibility for proper operations performed in the US into credibility for XIN as a whole, that would be a very high hurdle to set up for themselves were the intent merely to lend audit credibility to the company. By keeping Mr. Gurnee as CFO even after his Longtop fiasco, it appears management is not overly concerned with appearances. Also, the Williamsburg project is not insubstantial. A project performed merely for appearances would probably be of smaller scale.

Exit conditions

Management seems to harbor a propensity to "buy pullbacks," as evidenced by its refusal to execute on its share buyback program because the share price hadn't dipped enough, in its view, and by the fact that management refused to buy land in late 2010 as prices rose, but then bought several parcels right after prices dipped slightly in late 2011. This is classic price response behavior wired into every human's brain-behavior that must be unlearned to become a successful trader. In my experience as a trader, this is a recipe for disaster. Therefore, my job is to follow the trend where management finds this psychologically difficult. So if the macro winds shift such that the longer-term trend in Chinese housing prices appears to have inflected into a downtrend, my job is to exit XIN as soon as possible, as management will most likely begin engaging in a land buying spree at exactly the wrong time.

Disclaimer: I am currently long but tend to trade more actively that most, so I may sell or even short temporarily at any time. I also may buy extra if I think this write-up seems to be persuasive to the market. This is an investment idea, not a trade recommendation. I have done this research to the best of my abilities, but there may be inaccuracies. Also, my opinions or ideas may change at any time as I receive more information from the market.

Source: Xinyuan Real Estate's Fair Value Is Probably Over $15 Per Share