By Mike McDermott
On Friday, traders received a unique view into the investor appetite for Chinese real estate exposure. SouFun Holdings (SFUN) priced its IPO at $42.50 per share which was at the top of the proposed range and raised roughly $124.7 million.
Only a small portion of the funds actually went to the company, with the majority of capital being allocated to the selling shareholders. Chief among these shareholders is Telstra International (OTCPK:TLSYY) – an Australian phone company who was previously the majority owner of the company.
Private equity companies General Atlantic and Apax Partners will be taking over the remaining Telstra position and will likely be looking for additional exit points along the way to monetize their investment. Deutsche Bank (DB) and Goldman Sachs (GS) were the primary bookrunners for the transaction – in which the underwriters booked $8.7 million in fees – nearly as much as SouFun Holdings received from investors.
It was extremely impressive to see the stock rise to $73.50 on its first day of trading – a gain of 73% which puts SFUN as the second best IPO performance this year (second to MMYT’s 89% rise in August). But the big question at this point is whether SFUN can maintain this premium price – or if it will retrace the initial gain and test the original IPO price.
In a strongly trending bull market, I might be tempted to take a long position quickly in anticipation of continuing demand for the stock. After all, the underwriters had enough demand to price the stock at the high end of the range and still have investors competing to pick up more shares. The Wall Street Journal discussed a new catchphrase “scarcity premium“ which is supposed to describe the rationale for paying a premium price to get something that is not readily available…
I understand the concept, but the logic sounds fishy to me… Along with “scarcity” usually comes illiquidity. And in this environment, illiquidity is rarely tolerated. Once we get past the hype of SFUN’s exposure to a market that is not readily available to most US investors, institutional managers will likely start to worry about whether they can exit their position should the Chinese economy continue to experience growing pains.
The book The Invisible Hands by Steven Dronby discussed how endowment funds and pension managers made widespread decisions to own illiquid assets, expecting to realize a premium return because of the illiquid nature of the positions – and the expectation that they would be able to pick up these assets at a discount as they were less attractive to the general investing community.
The problem was that when so many managers were ALL after the same “illiquid” investments, the purchase prices were often similar to any liquid investment – but the long-term return didn’t give them any additional benefit for holding these assets.
A “scarcity premium” has similar undertones on a bit of a smaller scale – and I would not be surprised to see a number of these “scarce” investments become bull traps once the hype and initial attractiveness wears off.
Chinese Real Estate Investments
According to the prospectus, SouFun operates one of the leading real estate internet portals in China with information on available real estate coupled with home furnishing and home improvement offerings. The website offers marketing services to real estate developers – a business somewhat similar to the US Multiple Listing Service (or MLS).
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The ownership structure is quite convoluted as you can see by clicking on the image to the right. Although there is some necessity to creating offshore vehicles and sub-corporations in order to allow for international investment, a structure like this can at times raise red flags for institutional and retail investors alike.
The company is currently operating a profitable business with net income of $5.3 million in the first half of this year (on revenue of $68.2 million). Revenue growth has been very strong over the last year and over the last four quarters the company posted growth between 20% (in the September ‘09 quarter) and 126% (in the December ‘09 quarter)
SFUN competes against China Real Estate Information (CRIC) which experienced its own sharp rally in response to SFUN’s successful pricing. In October of last year, CRIC was spun out of E-House China (EJ) at an IPO price of $12.00. CRIC rallied 18% in its first day of trading and tacked on additional gains the next day. However, CRIC failed to follow through and within a few weeks it traded back below the IPO price.
Even after its rally last week, CRIC still sits nearly 20% below its original IPO price:
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It’s no secret that China has been struggling to figure out how to manage its own real estate bubble. Over the past couple of years we have received conflicting reports from the governing bodies as to how they will regulate the real estate market. There have been curbs placed on the number of properties speculators are allowed to purchase, and constraints on the price portion that can be financed versus the down payment required…
The stated goal is to keep speculators from pushing housing prices to an unhealthy level where residents of particular cities are unable to afford housing in the areas where they work. While the problem is most prevalent in major cities such as Beijing, a bubble in real estate prices could be very damaging to the economic foundation of the entire country.
But regulators are also aware of how dangerous it can be to deflate a bubble like this during an global economic recession - and this is why there has been so much conflicting rhetoric.
At present, the environment appears to favor keeping the bubble inflated – which is favorable for equities like EJ, CRIC and SFUN. However, I’m concerned that investors are pricing in the best scenario and could be caught leaning the wrong way the next time the rules change.
With that said, I’ll be watching SFUN very closely with an eye towards participating on the short side if and when the hype wears off. Over the next few days, I expect the stock to develop some areas of support and resistance. Keying off these levels will allow me to set potential entry prices and manage risk accordingly.
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At the same time, E-House China is beginning to look interesting as it approaches resistance in the low $20’s. I’m not ready to set up a short entry quite yet, but the setup is certainly on my watch list.
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The price action in many Chinese-related companies continues to be a bit difficult to game. But with clarity comes opportunity – and once visibility becomes a bit clearer we will have a number of setups worth pursuing.
Disclosure: As active traders, authors may have positions long or short in any securities mentioned. Full disclaimer can be found here.