On August 26 Xinyuan Real Estate (XIN) announced that TPG has invested $109 million in the company through the purchase of convertible notes and common shares. Assuming the convertible notes are fully converted, TPG will hold about 20% Xinyuan's total share capital. That is a nice deal for TPG - the common shares were issued at $5.48/share, while the stock book value is $12/share, and Xinyuan already has plenty of cash on its balance sheet. However, this is a must-do deal for Xinyuan. For too long has Xinyuan lacked a big-stake big-name institutional backer, and as a result, everyone thought it must be a lemon and investors have abandoned it. No more.
Xinyuan needs a big-name big-stake backer, badly
Xinyuan is the first Chinese real estate developer to be listed on the New York Stock Exchange. And until now it is the only major Chinese homebuilder listed in the U.S. How did it do that? With the backing of big-name institutional backers - Sam Zell of Equity International and John Griffin of Blue Ridge Capital.
Chinese homebuilders of Xinyuan's statue and scale usually choose to IPO on the Shanghai Stock Exchange and Hong Kong Stock Exchange. It's easier and cheaper. Xinyuan is an exception. Why? Because the CEO Yong Zhang has a bit of a U.S. obsession. The IPO process on NYSE is more difficult and more rigorous, and the Sarbanes Oxley requirements make it expensive and high maintenance - Xinyuan paid more than $1 million in 2012 for Ernst & Young's audit fees. But it's worth it. The CEO likes the prestige that comes with the NYSE listing.
CEO Yong Zhang did not spend an extensive amount of time working in the U.S. Xinyuan is more of a locally-grown business and the management has been not very effective in communicating with U.S. investors, demonstrated by its low stock price. And Yong Zhang is a low-key person. While his personality has served the company well in the hot-and-cold Chinese housing market, overseas investors undervalue the business because of its low profile. Therefore, the big-name big-stake hedge fund backer becomes the key. It serves as the bridge, the confidence support. All other institutional investors will now know, OK this is not a lemon.
I have been writing articles on Xinyuan and I have heard from a lot of people and have done a lot of research. So far, besides attacks on the country and its people in general, there has not been one thread of concrete evidence showing that Xinyuan, over its 16-year operating history, has participated in fraudulent activities or engaged in unethical business conducts or has had any accounting irregularities. If anyone has any additional information, please - I am all ears. I am willing to pay for any evidence that Xinyuan is not legitimate or not well-run. However, the most convincing argument from the doubters, and I had to agree with them at the time, is: "if the company is so undervalued, how come no major institutional investor is taking a large stake? There must be something fishy."
Now that TPG has taken a 20% stake, the puzzle is solved. One reason is that the stock's trading volume was low, and institutional investors cannot take a large enough stake without pushing up the stock price. It is a liquidity issue.
It is expensive to do an in-depth due diligence, and for smaller companies, it may not be worth the effort. Before TPG made its $109 million investment, it had to go through the whole process - cash audits, site visits, accounting books check, independent verification, off-balance sheet financing check, management background check, private investigation, etc. Especially given that how sensitive institutional investors are these days, a lot of precautions have to be taken to safeguard TPG's interest.
Some estimate that the whole in-depth due diligence can cost $3 million to $5 million, including labor, consultant expenses, corporate investigator expenses, independent auditing fees, background check fees, etc. Some even estimate the total cost can be more than $7 million. So previously, no hedge funds wanted to spend the money and brain damage to do the deep due diligence, and instead they waited for a leader to emerge to spend the money and effort. TPG has emerged, and the bridge is built. Shrewd institutional investors will follow suit to rely upon the confidence of the lead backer, and ride on TPG's coattails.
TPG's reputation is now on the line. TPG will put one guy on Xinyuan's board following its investment. This board member will make sure Xinyuan maximizes shareholder values. Over the next several years, if anything goes wrong with Xinyuan, TPG's reputation will be damaged along with its investment, and if push comes to shove, TPG will certainly go to court and vigorously pursue anyone in sight to maximize shareholders value. Although I believe the downside case will never happen - TPG will look pretty and reap hundreds of millions of dollars of profit and doubles its investment within a relatively short period of time. And all investors will be happy.
Xinyuan and SouFun - A Tale of Two Cities
At the end of 2Q, based on 13F filings, no institutional investor holds more than $13 million, or 4.2% of Xinyuan shares. Below are the top 10 holders, which collectively own less than 10% of Xinyuan.
By contrast, SouFun Holdings (SFUN) has its big-name big-stake backer - General Atlantic, a private equity firm that Julian Robertson likes. General Atlantic owns $374 million, or 19.3% of SouFun. As a result, other institutional investors followed suit and 3 other funds hold SouFun as one of their top 5 holdings. Below are the top 10 holders, which collectively own more than 30% of SouFun.
What I don't like about Xinyuan
Xinyuan has limited land inventory and has a fast turnover business model. I suggest the company should slow down the sale of its existing condos and homes, allowing them to take time to appreciate more. The company should also build a bigger land inventory - investors like that, even though it increases risks. If Xinyuan just sits on its finished condos and apartments without selling them, I would like it more and its book value would grow faster than the company holding so much cash. Prime location developments like the Beijing Xindo Park and Williamsburg 421 Kent Ave don't come often. I would even like to hold on to them forever, if possible.
Xinyuan has more cash on hand compared to its peers. This business model will cause Xinyuan to underperform in an environment that land price appreciates rapidly and outperform in a volatile and risky environment that property prices fluctuate or drop. In other words, Xinyuan is safer and more defensive than other homebuilders but in the current hot real estate market, Xinyuan's profitability may appear lackluster.
The management of Xinyuan has been very low-key. There can be several months without much update. Xinyuan's homes and apartments are selling briskly in Zhengzhou and Jinan but shareholders do not know. While the lack of handholding is fine for sophisticated institutional investors, the majority of Xinyuan shareholders are unsophisticated mom-and-pop investors. They would perform dubious technical analyses and read tea leaves and then rush to sell their ownership in a wonderful business at 44% of book value. That's why more institutional ownership is needed.
What I like about Xinyuan
Xinyuan consistently pays dividends and does share buybacks. CEO Yong Zhang owns 38.9% of all shares and has not sold shares over 5 years.
I spoke with a few Xinyuan managers and employees and they are buying the company's shares.
The Most Important Thing
I have been bullish on Xinyuan and have invested my own capital in its stock. I am not an imprudent investor, and I have done my due diligence which I summarized here and here. Most importantly, my confidence in the company comes down to the basic read of the CEO.
On May 22, 2012, Xinyuan CEO Yong Zhang, along with board member Yong Cui, appeared on TV and talked about Xinyuan's IPO, operations, housing market, Muddy Waters, accounting fraud in certain Chinese companies that hurt investor confidence, etc. The 82-minute interview (in Chinese) can be viewed here and the Chinese transcript can be viewed here. 6 minutes into the interview, the host asked Yong Zhang's view on Muddy Waters' bear raids on some Chinese companies and his view on Xinyuan's depressed valuation. Yong Zhang replied that, the U.S. capital market has rigorous regulations and those bear raids facilitate maintaining the long term healthy development of the market. Then the host asked: "Xinyuan is not a fraud, is it?" Yong Zhang laughed and his body language shows relaxation and he maintained eye contact, while replying "Of course no." Then he went on to say, yes a few Chinese companies engaged in fraudulent activities but those are rare cases; yes currently Xinyuan is undervalued but over the long term the stock price will reflect its intrinsic value.
I look into his eyes and believe him - Xinyuan's management is trustworthy. I have seen people lying in real life and on TV and I have seen good liars and bad liars. My read of Yong Zhang's interview and his eyes and his body language is that he is a sincere and honest and capable executive. He truly believes in his company and he wants to serve his shareholders' interest.
I feel comfortable that Xinyuan has a good management and is managed by capable executives who are knowledgeable and experienced and hard-working. And I agree with the CEO's view on the stock price - the shareholders should not be too concerned with erratic fluctuations in stock prices, since in the short term, the stock market behaves like a voting machine, but in the long term it acts like a weighing machine.
I have previously analyzed Xinyuan's background and valuation and here is an update: at the end of 2Q Xinyuan had a book value of $11.94/share and the trailing 12-month net income is $1.82/share. The current stock price of $5.50 reflects a 0.44x Price/Book ratio and 2.99x P/E. By comparison, the stock finished its first day of trading after IPO with a 2.49x P/B and 24.9x P/E. Applying those multiples, Xinyuan should be trading at $29.73/share and $45.32/share, respectively.
More important is the company's prospect. With several mega projects being launched, I expect the company's annual revenue to soon exceed $1 billion and net income to grow significantly over the next year.
Xinyuan's Beijing Xindo Park project will launch its presale at the end of September. It is nicely located 200 meters from the Beijing subway 4 Train station. Beijing home price rose 14% in July, and shows signs of robust growth. Below is how the Beijing Xindo Park project will look like.
Xinyuan's Brooklyn project is just as hot. The 421 Kent Ave location is prime and home prices in the borough are at a 10-year high, increasing 14.7% year-over-year, with inventory at a seven-year low. It is the first time a Chinese company has bought a U.S. development site planned for more than a few units. Below is how the Brooklyn project will look like.
Target Price: Raised to $19/share
Given Xinyuan's growth prospect, I think it is worth a 1.58x price/book multiple, or $19/share. With TPG's $109 million endorsement, Xinyuan has handed out the last piece of the puzzle. This endorsement will resolve the lack of institutional investor confidence. It's not easy for a Chinese company to be listed on the NYSE. And it's much harder to be the first in one category. Sina (SINA) is an example. It is the first major Chinese Internet company to be listed on the NASDAQ.
Similar to Xinyuan, Sina did its IPO at the peak of an economic cycle - in April 2000. After the IPO, the stock price jumped to $47.80, then the dot com bubble burst, and there was a beaten-down period. Sina's stock fell to the $1.00 range. 2 years later, investors regained their confidence and Sina's stock climbed back to $40 quickly.
And here is a look at Xinyuan's chart:
Xinyuan's stock price closed at $16.80 after its IPO, and it has been 5 years, 8 months, 17 days (and counting) that Xinyuan hasn't been able to climb back to that level. Sooner or later it will happen. And then it will go higher.
I believe Xinyuan is a wonderful business that will prosper. I believe that in the future there will be more and more great Chinese companies to be listed in the U.S. I am optimistic that the future is bright.
I like Xinyuan as much as Warren Buffett likes Coca Cola (KO) - he hasn't sold his shares for 25 years. I am confident, and I am sure TPG would agree with me, that in 5, 10, and 20 years, Xinyuan will continue to build wonderful homes and condos around the world, and will continue to pay dividends and buyback shares, and investors will recognize its value and the stock will one day be trading at a level far exceeding $50/share. And I will tell my kids and grandkids the story that once upon a time it was trading at $5.50/share and how we stared at the opportunity in the eye, and did not miss it.