Author update (November 24, 2010): The following content is based on the false assumption that employee compensation was priced in thousands, similarly to the balance sheet. This assumption is wholly inaccurate. I have read through Xinyuan documentation many times, and mis-interpreted it for the first time two days ago. I think I panicked trying to justify substantial recent price declines, institutional selling, and very low valuation in the face of relatively strong performance, strong guidance, and rising analyst estimates. I have apologized to management, and I apologize to SA as well.
I previously expressed the opinion that Xinyuan Real Estate (XIN) would likely prosper under most likely scenarios. I believe that I made a major mistake valuing the company.
The company's 2010 20-F addresses dilution on P.94 as "not applicable", and the company's most recent balance sheet values "common shares" under shareholder equity at $15,000. In recent email correspondence with Tom Gurnee (the CFO), he described potential foreseeable shareholder dilution as, "very small."
The problem is that the company's, "stock based compensation plan", may end up diluting shareholders by a factor of more than 10X by 2020. There is a 1:2 ratio of ADS to common shares with ADS shares trading on the NYSE. There are currently 156,114,000 outstanding "common shares", and 78,057,000 ADS shares.
Below is a list of potential dilution (click to enlarge):
Tom Gurnee alone has options on 500,000 common shares. That's more than 3x the current outstanding shares.
Considering the level of share based compensation provided to executives relative to outstanding shares, and the fact that Yong Zhang and his wife own the majority of the company, it's reasonable to question whether management will act in the best interest of non employee shareholders going forward.
The company's 20F states that,
Under US GAAP, we are required to recognize the fair value of the outstanding warrants as a liability on our balance sheet. We determine the fair value of the warrants on a quarterly basis using the Black-Scholes valuation method with increases/decreases in value resulting in a charge/credit to “change in fair value of derivative liabilities.
I believe that options on, "Common Shares" are a material liability, and thus the company is providing unethical financial statements.
Initially, I put substantial faith in Ernst and Young China, (Ernst and Young Hua Ming), three analysts, several institutional buyers, and the company its self, which lead me to believe that XIN shares were poised for price appreciation.
In light of very heavy likely dilution, what I consider to be deceptive disclosure, and macro business risks, I do not consider XIN to be a good investment.
I regret to report that I have sold my long position. I genuinely believed that XIN shares had tremendous potential upside, and lost money on my investment. I believed the market was pricing in a unrealistic drop in China tier II real estate, and the company was unlikely to be misleading investors. I now believe that I was wrong regarding the company.
Disclosure: No positions